MODULE 1 wants.
For example, a piece of land can be used for either cultivation, or building a dwelling
MEANING OF ECONOMICS
The word ‘Economics’ originates from the Greek work ‘Oikonomikos’ which can be divided
into two parts:
(a) ‘Oikos’, which means ‘Home’, and
(b) ‘Nomos’, which means ‘Management’.
Thus, Economics means ‘Home Management’. The head of a family faces the problem of
managing the unlimited wants of the family members within the limited income of the family.
In fact, the same is true for a society also. If we consider the whole society as a ‘family’, then
the society also faces the problem of tackling unlimited wants of the members of the society
with the limited resources available in that society. Thus, Economics means the study of the
way in which mankind organises itself to tackle the basic problems of scarcity. All societies
have more wants than resources. Hence, a system must be devised to allocate these resources
between competing ends.
DEFINITIONS OF ECONOMICS
We have now formed an idea about the meaning of Economics. This at once leads to a general
definition of Economics. Economics is the social science that studies economic activities. This
definition is, however, too broad. It does not specify the exact manner in which the economic
activities are to be studied. Economic activities essentially mean production, exchange and
consumption of goods and services. However, with the progress of civilisation, the complexity
of the production, exchange and consumption processes in society have increased manifold.
Economists at different times have emphasised different aspects of economic activities, and
have arrived at different definitions of Economics. Some of these definitions in detail. These
definitions can be classified into four groups:
1. Wealth definitions,
2. Material welfare definitions,
3. Scarcity definitions, and
4. Growth-centred definitions.
Adam Smith’s Definition
Adam Smith, considered to be the founding father of modern Economics, defined Economics
as the study of the nature and causes of nations’ wealth or simply as the study of wealth. The
central point in Smith’s definition is wealth creation. Implicitly, Smith identified wealth with
welfare. He assumed that, the wealthier a nation becomes the happier are its citizens. Thus, it
is important to find out, how a nation can be wealthy. Economics is the subject that tells us
how to make a nation wealthy. Adam Smith’s definition is a wealth-centred definition of
Economics.
Main Characteristics of Wealth Definitions
1. Exaggerated emphasis on wealth: These wealth centered definitions gave too much
importance to the creation of wealth in an economy. The classical economists like Adam Smith,
J.S. Mill, J.B. Say, and others believed that economic prosperity of any nation depends only on
the accumulation of wealth.
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person who employs is called employer and the person who is employed is called employee or
worker.
3. Business: Business is an economic activity concerned with production and distribution of
goods and services with the aim to earn profit. It includes all those activities which are directly
or indirectly concerned with production, purchase and sale of goods and services. So the
production, marketing, advertising, warehousing, insurance, banking, etc. are all business
activities.
NON ECONOMIC ACTIVITIES:
"Human activities which are not performed for money or money's worth are called non-
economic activities. “Here, there is no monetary consideration in exchange for such
activities.Non-economic activities, do not have economic motive and are undertaken on
account of love, affection, social, cultural or religious reasons.
Non-economic activities are those activities which are pursued because of social, religious,
cultural, psychological or sentimental reasons. These activities have no economic motive but
are undertaken to have self-satisfaction. These activities are voluntary in nature and are
undertaken at the leisure or pleasure of the person pursuing them. The examples of such
activities may be: a housewife working at home, a person engaged in social work, attending a
religious activity, listening to a discourse by a saint, attending to accident victims by volunteers
etc. All these activities are done for one’s own satisfaction.
ENGINEERING ECONOMICS
Engineering economics is the application of economic principles and calculations to
engineering projects. It is important to all fields of engineering because no matter how
technically sound an engineering project is, it will fail if it is not economically feasible.
Engineering economic analysis is often applied to various possible designs for an engineering
project in order to choose the optimum design, thereby taking into account both technical and
economic feasibility.
Definition
Engineering economics deals with the methods that enable one to take economic decisions
towards minimizing costs and/or maximizing benefits to business organizations.
Engineering economics, previously known as engineering economy, is a subset of economics
for application to engineering projects. Engineers seek solutions to problems, and the economic
viability of each potential solution is normally considered along with the technical aspects.
Fundamentally, engineering economics involves formulating, estimating, and evaluating the
economic outcomes when alternatives to accomplish a defined purpose are available.
Engineering economics is the branch of science which deals with the concepts and techniques
of analysis useful in evaluating the worth of systems, products, and services in relation to their
costs.
Engineering economics is the application of economic techniques to the evaluation of design
and engineering alternatives. The role of engineering economics is to assess the appropriateness
of a given project, estimate its value, and justify it from an engineering standpoint.
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place or building a factory shed, etc.
4. Efficient use of scarce resources: Since wants are unlimited, so these wants are to be ranked
in order of priorities. On the basis of such priorities, the scarce resources are to be used in an
efficient manner for the satisfaction of these wants.
5. Need for choice and optimisation: Since human wants are unlimited, so one has to choose
between the most urgent and less urgent wants. Hence, Economics is also called a science of
choice. So, scarce resources are to be used for the maximum satisfaction (i.e., optimisation) of
the most urgent human wants.
Modern Growth-Oriented Definition of Samuelson
In relatively recent times, more comprehensive definitions of Economics have been offered.
Thus, Professor Samuelson writes, “Economics is the study of how people and society end up
choosing, with or without the use of money, to employ scarce productive resources that could
have alternative uses to produce various commodities over time and distributing them for
consumption, now or in the future, among various persons or groups in society. It analyses
costs and benefits of improving patterns of resource allocation”. A large number of modern
economists subscribe to this broad definition of Economics.
Features of the Modern Growth-Oriented Definition
1. Growth-orientation: Economic growth is measured by the change in national output over
time. The definition says that, Economics is concerned with determining the pattern of
employment of scarce resources to produce commodities ‘over time’. Thus, the dynamic
problems of production have been brought within the purview of Economics.
2. Dynamic allocation of consumption: Similarly, under this definition, Economics is
concerned with the pattern of consumption, not only now but also in the future. Thus, the
problem of dividing the use of income between present consumption and future consumption
has been brought within the orbit of Economics.
3. Distribution: The modern definition also concerns itself with the distribution of
consumption among various persons and groups in a society. Thus, while the problem of
distribution is implicit in the earlier definitions, the modern definition makes it explicit.
4. Improvement of resource allocation: The definition also says that, Economics analyses
the costs and benefits of improving the pattern of resource allocation. Improvement of resource
allocation and better distributive justice are synonymous with economic development. Thus,
issues of development of a less developed economy have also been made subjects of the study
of Economics.
To put it summarily, the modern definition of Economics is the most comprehensive of all the
definitions. All the issues that were highlighted in the earlier definitions are included here. In
addition, the issues of development of a backward economy, as well as those of growth in a
mature capitalist economy, form part of this definition. Economics as it stands today, is built
on the basis of this comprehensive definition.
ECONOMIC ACTIVITIES:
Economic activities are related to production, distribution, exchange and consumption of goods
and services. The primary aim of the economic activity is the production of goods and services
with a view to make them available to consumer.
Engineering Economic Decisions:
This term refers to all investment decisions relating to engineering projects. The most
interesting facet of an economic decision, from an engineer’s point of view, is the evaluation
of costs and benefits associated with making a capital investment.
The five main types of engineering economic decisions are:
1. Service or Quality improvement
2. New products or product expansion
3. Equipment and process selection
4. Cost reduction
5. Equipment replacement
FUNDAMENTAL OR BASIC ECONOMIC PROBLEMS
All modern economies have certain fundamental or basic economic problems to deal with. In
every single economy, including the so-called “affluent society”, resources are limited. As a
result, decisions regarding the resource use have to be made together by individuals, by
business corporations, and by society. It is the social choice and community preferences which
give substance to the question of macro-economic decisions. Three Basic Economic Problems
are:
™ What to produce?
Each and every economy must determine what products and services, and what volume of each,
to produce. In some way, these kinds of decisions should be coordinated in every society. In a
few, the govt decides. In others, consumers and producers decisions act together to find out
what the society’s scarce resources will be utilized for. In a market economy, this ‘what to
produce?’ choice is made mainly by buyers, acting in their own interests to fulfill their needs.
Their demands are fulfilled by organizations looking for profits.
How to produce?
This basic economic problem is with regards to the mix of resources to use to create each good
and service. These types of decisions are generally made by companies which attempt to create
their products at lowest cost. By way of example, banking institutions have substituted the
majority of their counter service individuals with automatic teller machines, phone banking
and Net banking. These electronic ways of moving money, utilizing capital as opposed to labor
resources, have decreased the banks’ production costs... The initial approach to production,
using a resource combination which includes a small capital and much labor, is labor-intensive
while the second, utilizing a little labor and a lot of capital, is capital-intensive. Each one of
these ‘how’ decisions were made based on lowest cost and accessible modern technology.
 Human activities which are performed in exchange for money or money's worth are called
economic activities." In other words, economic activities are those efforts which are
undertaken by man to earn Income, Money, and Wealth for his life and to secure maximum
satisfaction of wants with limited and scarce means.
E.g. A worker works in a factory and gets wages.
Characteristics of Economic Activities:
1. Wealth Producing Activities: The economic activities are undertaken to produce wealth.
The wealth is produced by productive activities. The production may be for the consumption
of family members or for the others. A farmer may grow vegetables for his family consumption
and for selling in the market. The produce sold in the market will fetch income for the farmer.
2. Satisfying Human Wants: The main aim of economic activities is to satisfy human needs.
The needs to be satisfied may be present or future. When a person undertakes a job to earn
money and buy necessities for his family then it will be satisfying present needs. On the other
hand when a person saves money out of his current earnings for satisfying his needs after the
retirement then it will be a plan for the future.
3. Money Income: All economic activities, these may be related to business, profession or
service, help in earning money income. People undertake these activities to satisfy their family
needs with the help of money earned through productive activities. A living is possible with
money income earned from economic activities.
4. Developmental Activities: Economic activities not only satisfy human wants but also
become a basis for economic development of the society. When old needs are satisfied then
new needs crop up. The economic resources are employed to produce new products and this
process helps in generating employment avenues and ultimately the money income. The social
development is linked to the economic activities undertaken there.
Types / Classification of Economic Activities
1. Profession: Profession is an occupation carried on by professional people like Doctors,
Lawyers, Engineers, etc. They provide specialised services in return for fees. To become a
professional, a man requires specialized knowledge and professional qualification. For e.g.
Doctor Need’s specialised knowledge in medicine, a lawyer needs a degree in law, etc
2. Employment: Employment is a type of occupation under which one person provides his
services, physical or mental to someone else in return for which he gets salary or wage. The
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™ For whom to produce?
This basic economic question is focused on who receives what share of the products and
services which the economy produces. The portion of production which each person and family
can consume is determined by their income. Income is distributed in line with the value of
resources we have to sell.
Other Economic problems are:
™ Problems of Efficiency and Growth:
Besides the three fundamental problems explained above, there are two other problems of an
economy to which economists of today attach considerable importance. They are the problems
of efficiency and growth of the economy.
™ Efficiency of Resource-use:
A very important question that can be asked about the working of an economy is: Are the
resources being used efficiently? Since resources are scarce, it is obviously desirable that they
should be most efficiently used, i.e., the production and distribution of the national product
should be efficient. Production is said to be efficient, if it is not possible to produce more of
one good without reducing the output of any other goods in the economy. Similarly the
distribution is efficient if it is not possible to make any one person/persons better off without
making any other person/persons worse off through any redistribution.
™ Growth of Productive Capacity:
It is also important to know whether the productive capacity, of an economy is increasing, static
or declining. The increase in productive capacity of an economy over time is called economic
growth. Obviously, for under-developed economies, their basic problem is how to accelerate
the pace of their economic growth.
Even developed countries would not like to rest on their oars. In fact, it has been observed that
they are able to achieve higher annual rate of growth than the under-developed ones. The
problem of growth is thus not peculiar to the under-developed countries, but is of importance
to all countries, whether developed or undeveloped, whether free-market or centrally planned.
FACTORS OF PRODUCTION
Factors of production refer to an economic term to describe the inputs that are used in the
production of goods or services in the attempt to make an economic profit. Factors of
production means the Resources required for generation of goods or services and the four
factors of production are:
1. Land (including all natural resources),
2. Labour (including all human resources),
3. Capital (including all man-made resources), and
4. Enterprise/ Entrepreneur (which brings all the previous resources together for production)
Primary inputs are also called factor inputs and secondary inputs are known as nonfactor inputs.
Alternatively, production is undertaken with the help of resources which can be categorised
into natural resources (land), human resources (labour and entrepreneur) and manufactured
resources (capital).
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2. Inquiry into the creation of wealth: These definitions show that Economics also deals with
an inquiry into the causes behind the creation of wealth. For example, wealth of a nation may
be increased through raising the level of production and export.
3. A study on the nature of wealth: These definitions have indicated that wealth of a nation
includes only material goods (e.g., different manufactured items). Non-material goods were
not included. Hence, non-material goods like services of teachers, doctors, engineers, etc., are
not considered as ‘wealth’.
Alfred Marshall’s Definition
Alfred Marshall also stressed the importance of wealth. But he also emphasised the role of the
individual in the creation and the use of wealth. He wrote: “Economics is a study of man in the
ordinary business of life. It enquires how he gets his income and how he uses it. Thus, it is on
the one side, the study of wealth and on the other and more important side, a part of the study
of man”. Marshall, therefore, stressed the supreme importance of man in the economic system.
Marshall’s definition is considered to be material-welfare centred definition of Economics.
Features of Material Welfare Definitions
1. Study of material requisites of well-being: These definitions indicate that Economics
studies only the material aspects of well-being. Thus, these definitions emphasise the
materialistic aspects of economic welfare.
2. Concentrates on the ordinary business of life: These definitions show that Economics
deals with the study of man in the ordinary business of life. Thus, Economics enquires how an
individual gets his income and how he uses it.
3. A stress on the role of man: These definitions stressed on the role of man in the creation of
wealth or income.
Lionel Robbins’ Definition
The next important definition of Economics was due to Prof. Lionel Robbins. In his book
‘Essays on the Nature and Significance of the Economic Science’, published in 1932, Robbins
gave a definition which has become one of the most popular definitions of Economics.
According to Robbins, “Economics is a science which studies human behaviour as a
relationship between ends and scarce means which have alternative uses”. A long line of
economists after Robbins, including Scitovsky and Cassel agreed with this definition and
carried on their analysis in line with this definition. It is a scarcity-based definition of
Economics.
Main Features of Scarcity Definition
1. Human wants are unlimited: The scarcity definition of Economics states that human wants
are unlimited. If one want is satisfied, another want crops up. Thus, different wants appear one
after another.
2. Limited means to satisfy human wants: Though wants are unlimited, yet the means for
satisfying these wants are limited. The resources needed to satisfy these wants are limited. For
example, the money income (per month) required for the satisfaction of wants of an individual
is limited. Any resource is considered as scarce if its supply is less than its demand.
3. Alternative uses of scarce resources: Same resource can be devoted to alternative lines of
production. Thus, same resource can be used for the satisfaction of different types of human
It is used to answer many different questions:
™ Which engineering projects are worthwhile?
x Has the mining or petroleum engineer shown that the mineral or oil
deposits is worth developing?
™ Which engineering projects should have a higher priority?
x Has the industrial engineer shown which factory improvement projects
should be funded with the available dollars?
™ How should the engineering project be designed?
x Has chemical or process engineer chosen the best thickness for
insulation?
SCOPE OF ENGINEERING ECONOMICS
™ Concerned with the monetary consequences or financial analysis of the projects,
products and processes that engineers design.
™ Economic concepts are used in the major fields such as increasing production,
improving productivity, reducing human efforts, increasing wealth by maximising
profit, controlling and reducing cost.
™ Engineering economics provides a number of tools and techniques to solve engineering
problems related to product mix, output level, pricing, investment, quantum of
advertisement etc.
™ Helps in understanding the market conditions, general economic environment in which
the firm is working.
™ Provides basis for resource allocation problem.
™ Deals with identification of economic choices, and is concerned with the decision
making of engineering problems of economic nature.
ROLE OF ECONOMICS IN ENGINEERING DECISION MAKING
Decisions are made routinely to choose one alternative over another by individuals in everyday
life; by engineers on the job; by managers who supervise the activities of others; by
corporate presidents who operate a business; and by government officials who work for the
public good. Most decisions involve money, called capital or capital funds, which is usually
limited in amount. The decision of where and how to invest this limited capital is motivated by
a primary goal of adding value as future, anticipated results of the selected alternative are
realized.
Engineers play a vital role in capital investment decisions based upon their ability and
experience to design, analyse, and synthesize. The factors upon which a decision is based are
commonly a combination of economic and noneconomic elements. Engineering economy deals
with the economic factors.
By definition, engineering economy involves formulating, estimating, and evaluating the
expected economic outcomes of alternatives designed to accomplish a defined purpose.
 (i) Land: It refers to all natural resources which are free gifts of nature. Land, therefore,
includes all gifts of nature available to mankind—both on the surface and under the surface,
e.g., soil, rivers, waters, forests, mountains, mines, deserts, seas, climate, rains, air, sun, etc.
(ii) Labour: Human efforts done mentally or physically with the aim of earning income is
known as labour. Thus, labour is a physical or mental effort of human being in the process of
production. The compensation given to labourers in return for their productive work is called
wages (or compensation of employees).
Land is a passive factor whereas labour is an active factor of production. Actually, it is labour
which in cooperation with land makes production possible. Land and labour are also known as
primary factors of production as their supplies are determined more or less outside the
economic system itself.
(iii) Capital: All man-made goods which are used for further production of wealth are included
in capital. Thus, it is man-made material source of production. Alternatively, all man-made
aids to production, which are not consumed/or their own sake, are termed as capital. It is the
produced means of production. Examples are— machines, tools, buildings, roads, bridges, raw
material, trucks, factories, etc. An increase in the capital of an economy means an increase in
the productive capacity of the economy. Logically and chronologically, capital is derived from
land and labour and has therefore, been named as Stored Up labour.
(iv) Entrepreneur/ Entrepreneurship:
An entrepreneur is a person who organises the other factors and undertakes the risks and
uncertainties involved in the production. He hires the other three factors, brings them together,
organises and coordinates them so as to earn maximum profit.
For example, Mr. X who takes the risk of manufacturing television sets will be called an
entrepreneur. An entrepreneur acts as a boss and decides how the business shall run. He decides
in what proportion factors should be combined. What and where he will produce and by what
method. He is loosely identified with the owner, speculator, innovator or inventor and organiser
of the business. Thus, entrepreneur ship is a trait or quality owned by the entrepreneur.
CIRCULAR FLOW IN AN ECONOMY
The circular flow of income is a neoclassical economic model depicting how
money flows through the economy. In the simplest version, the economy is modelled as
consisting only of households and firms. Money flows to workers in the form of wages, and
money flows back to firms in exchange for products. This simplistic model suggests the old
economic adage, "Supply creates its own demand."
A model that indicates how money moves throughout an economy, between businesses and
individuals. Investors spend their income by consuming goods and services from
businesses, paying taxes and investing in the stock market. Businesses use the money spent by
individuals while consuming and the money raised from selling stock to pay for capital to run
their business, purchase material to manufacture products and to pay employees.
All expenditures from individuals become the income of the businesses, and the expenditures
of the businesses become the income of the individuals.
9 11
x Giffen good: A rare type of good, where an increase in price causes an increase in demand.
The reason is that the income effect of a rise in the price causes you to buy more of this cheap
good because you can’t afford more expensive goods. For example, if the price of wheat rises,
a poor peasant may not be able to afford meat anymore, so has to buy more wheat.
x Veblen / Snob good. A good where an increase in price encourages people to buy more of it.
This is because they think more expensive goods are better.
™ Market Failure
x Public goods – goods with characteristics of non-rivalry and non-excludability, e.g. national
defence.
x Merit goods. Goods which people may underestimate benefits of. Also often have positive
externalities, e.g. education.
x Demerit goods. Goods where people may underestimate costs of consuming it. Often have
negative externalities, e.g. smoking, drugs.
x Private goods – goods which do have rivalry and excludability. The opposite of a public good
x Free goods – A good with no opportunity cost, e.g. breathing air.
ƒ UTILTY
Utility refers to want satisfying power of a commodity. It is the satisfaction, actual or expected,
derived from the consumption of a commodity. Utility differs from person- to-person, place-
to-place and time-to-time. In the words of Prof. Hobson, “Utility is the ability of a good to
satisfy a want”. In short, when a commodity is capable of satisfying human wants, we can
conclude that the commodity has utility. Utility is a term used by economists to describe the
measurement of “usefulness” that a consumer obtains from any good.
How to Measure Utility?
According to classical economists, utility can be measured, in the same way, as weight or height
is measured. For this, economists assumed that utility can be measured in cardinal (numerical)
terms. By using cardinal measure of utility, it is possible to numerically estimate utility, which
a person derives from consumption of goods and services. But, there was no standard unit for
measuring utility. So, the economists derived an imaginary measure, known as ‘Util’. Utils are
imaginary and psychological units which are used to measure satisfaction (utility) obtained
from consumption of a certain quantity of a commodity.
Example – Measurement of satisfaction in utils:
Suppose you have just eaten an ice-cream and a chocolate. You agree to assign 20 utils as
utility derived from the ice-cream. Now the question is: how many utils be assigned to the
chocolate? If you liked the chocolate less, then you may assign utils less than 20. However, if
you liked it more, you would give it a number greater than 20. Suppose, you assign 10 utils to
the chocolate, then it can be concluded that you liked the ice-cream twice as much as you liked
the chocolate.
One more way to measure utility: Utils cannot be taken as a standard unit for measurement
as it will vary from individual to individual. Hence, several economists including Marshall,
suggested the measurement of utility in monetary terms. It means, utility can be measured in
terms of money or price, which the consumer is willing to pay.
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5. Inflationary and Deflationary Tendencies: Leakages or injections in the circular flow
disturb the smooth functioning of the economy. For example, saving is a leakage out of the
expenditure stream. If saving increases, this depresses the circular flow of income. This tends
to reduce employment, income and prices, thereby leading to a deflationary process in the
economy. On the other hand, consumption tends to increase employment, income, output and
prices that lead to inflationary tendencies.
6. Importance of Monetary Policy: The study of circular flow also highlights the importance
of monetary policy to bring about the equality of saving and investment in the economy. The
credit market itself is controlled by the government through monetary policy. When saving
exceeds investment or investment exceeds saving, money and credit policies help to stimulate
or retard investment spending. This is how a fall or rise in prices is also controlled.
7. Importance of Fiscal Policy: The circular flow of income and expenditure points toward
the importance of fiscal policy. For national income to be in equilibrium desired saving plus
taxes (S+T) must equal desired investment plus government spending (I + G). S+ T represents
leakages from the spending stream which must be offset by injections of I + G into the income
stream. If S + T exceed I + G, government should adopt such fiscal measures as reduction in
taxes and spending more itself.
8. Importance of Trade Policies: Similarly, imports are leakages in the circular flow of money
because they are payments made to a foreign country. To stop it, the government adopts such
measures as to increase exports and decrease imports. Thus the circular flow points toward the
importance of adopting export promotion and import control policies.
9. Basis of Flow of Funds Accounts: The circular flow helps in calculating national income
on the basis of the flow of funds accounts. The flow of funds accounts are concerned with all
transactions in the economy that are accomplished by money transfers.They show the financial
transactions among different sectors of the economy, and the link between saving and
investment, and lending and borrowing by them. To conclude, the circular flow of income
possesses much theoretical and practical significance in an economy.
PRINCIPLES IN CIRCULAR FLOW OF INCOME:
The circular flow of income involves two basic principles:
(i) In any exchange process, the seller (or producer) receives the same amount which the buyer
(or consumer) spends.
(ii) Goods and services flow in one direction and the money payment to acquire them, flow in
the return direction giving rise to a circular flow. Thus, product flow from the seller to the
buyer is necessarily a complement of money (income) flow from the buyer to the seller.
Table: TU and MU
Ice-creams Marginal Utility
Consumed (MU) Total Utility (TU)
1 20 20
2 16 36
3 10 46
4 4 50
5 0 50
6 -6 44
In Fig., units of ice-cream, are shown along the X-axis and TU and MU are measured along
the Y-axis. MU is positive and TU is increasing till the 4th ice-cream. After consuming the
5th ice-cream, MU is zero and TU is maximum.
This point is known as the point of satiety or the stage of maximum satisfaction. After
consuming the 6th ice-cream, MU is negative (known as disutility) and total utility starts
diminishing. Disutility is the opposite of utility. It refers to loss of satisfaction due to
consumption of too much of a thing.
ƒ PRICE
In ordinary usage, price is the quantity of payment or compensation given by one party to
another in return for goods or services.
A value that will purchase a finite quantity, weight, or other measure of a good or service.
As the consideration given in exchange for transfer of ownership, price forms the essential
basis of commercial transactions. It may be fixed by a contract, left to be determined by an
15
 Income flows and product flows are equal:
The circular flows in the above diagram clearly prove that income flows in the form of factor
income and consumption expenditure, and product flows in the form of factor services and
final goods and services are equal.
The following conclusions can be derived from the given diagram:
(i) Total production of goods and services by Firms = Total consumption of goods and services
by Household sector
(ii) Factor payments by Firms = Factor Incomes of Household sector
(iii) Consumption expenditure of Household sector = Income of Household sector
(iv) Real flows of production and consumption of Firms and Households = Money flows of
Income and expenditure of Firms and Households.
BASIC TERMS AND CONCEPTS
ƒ GOODS:
In Economics Goods means, “A commodity or a physical, tangible item that satisfies some
human want or need, or something that people find useful or desirable and make an effort
to acquire it.
Goods that are scarce (are in limited supply in relation to demand) are called economic goods,
whereas those whose supply is unlimited and that require neither payment nor effort to acquire,
(such as air) are called free goods.'
Different types of economic goods:
™ Income elasticity of demand and types of goods
Income elasticity of demand measures the responsiveness of demand to a change in income.
x Inferior good: An inferior good means an increase in income causes a fall in demand. It has a
negative YED. An example, of an inferior good is Tesco value bread. When your income rises
you buy less Tesco value bread and more high quality, organic bread.
x Normal good. This means an increase in income causes an increase in demand. It has a positive
YED. Note a normal good can be income elastic or income inelastic.
x Luxury good. A luxury good means an increase in income causes a bigger % increase in
demand. It means that the YED is greater than one. For example, high definition TV’s would
be luxury. When income rises, people spend a higher % of their income on the luxury good.
(Note: a luxury good is also a normal good, but a normal good isn’t necessarily a luxury good)
™ Other types of goods
x Complementary goods: Goods which are used together, e.g. TV and DVD player.
x Substitute goods: Goods which are alternatives, e.g. Pepsi and Coca-Cola.
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agreed upon formula at a future date, or discovered or negotiated during the course of
dealings between the parties involved.
In commerce, price is determined by what (1) a buyer is willing to pay, (2) a seller is willing
to accept, and (3) the competition is allowing to be charged.
Pricing Methods
An organization has various options for selecting a pricing method. Prices are based on three
dimensions that are cost, demand, and competition. The organization can use any of the
dimensions or combination of dimensions to set the price of a product.
Cost-based Pricing: Cost-based pricing refers to a pricing method in which some percentage
of desired profit margins is added to the cost of the product to obtain the final price. In other
words, cost-based pricing can be defined as a pricing method in which a certain percentage of
the total cost of production is added to the cost of the product to determine its selling price.
Cost-based pricing can be of two types, namely, cost-plus pricing and mark-up pricing.
Two types of cost-based pricing are as follows:
i. Cost-plus Pricing:
Refers to the simplest method of determining the price of a product. In cost-plus pricing
method, a fixed percentage, also called mark-up percentage, of the total cost (as a profit) is
added to the total cost to set the price. For example, XYZ organization bears the total cost of
Rs. 100 per unit for producing a product. It adds Rs. 50 per unit to the price of product as’
profit. In such a case, the final price of a product of the organization would be Rs. 150.
Cost-plus pricing is also known as average cost pricing. This is the most commonly used
method in manufacturing organizations.
The advantages of cost-plus pricing method are as follows:
(a). Requires minimum information
(b). Involves simplicity of calculation
(c). Insures sellers against the unexpected changes in costs
The disadvantages of cost-plus pricing method are as follows:
a. Ignores price strategies of competitors
b. Ignores the role of customers
ii. Markup Pricing:
Refers to a pricing method in which the fixed amount or the percentage of cost of the product
is added to product’s price to get the selling price of the product. Mark-up pricing is more
common in retailing in which a retailer sells the product to earn profit. For example, if a retailer
has taken a product from the wholesaler for Rs. 100, then he/she might add up a markup of Rs.
20 to gain profit.
16
DIFFERENCE BETWEEN REAL FLOW AND MONEY FLOW
1. Real flow is the exchange of goods and services between household and firms whereas
money flow is the monetary exchange between two sectors.
2. In real flow household sector supplies raw material, land, labour, capital and enterprise
to firms and in return firms sector provides finished goods and services to household
sector. Whereas in money flow, firm sector gives remuneration in the form of money
to household sector a wages and salaries, rent, interest etc.
3. Difficulties of barter system for the exchange of goods and factor services between
households and firms sector in real flow, whereas no such difficulty or inconvenience
arise in money flow.
4. When goods and services flow from one sector of the economy to another, it is known
as real flow
IMPORTANCE OF THE CIRCULAR FLOW:
The concept of the circular flow gives a clear-cut picture of the economy. We can know
whether the economy is working efficiently or whether there is any disturbance in its smooth
functioning. As such, the circular flow is of immense significance for studying the functioning
of the economy and for helping the government in formulating policy measures.
1. Study of Problems of Disequilibrium: It is with the help of circular flow that the problems
of disequilibrium and the restoration of equilibrium can be studied.
2. Effects of Leakages and Inflows: The role of leakages enables us to study their effects on
the national economy. For example, imports are a leakage out of the circular flow of income
because they are payments made to a foreign country. To stop this leakage, government should
adopt appropriate measures so as to increase exports and decrease imports.
3. Link between Producers and Consumers: The circular flow establishes a link between
producers and consumers. It is through income that producers buy the services of the factors
of production with which the latter, in turn, purchase goods from the producers.
4. Creates a Network of Markets: As a corollary to the above point, the linking of producers
and consumers through the circular flow of income and expenditure has created a network of
markets for different goods and services where problems relating to their sale and purchase are
automatically solved.
10
In the above example, suppose 1 util is assumed to be equal to Rs. 1. Now, an ice-cream will
yield utility worth Rs. 20 (as 1 util = Rs. 1) and chocolate will give utility of Rs. 10. This utility
of Rs. 20 from the ice-cream or f I0 from the chocolate is termed as value of utility in terms of
money.
The advantage of using monetary values instead of utils is that it allows easy comparison
between utility and price paid, since both are in the same units.
It must be noted that it is impossible to measure satisfaction of a person as it is inherent to the
individual and differs greatly from person-to-person. Still, the concept of utility is very useful
in explaining and understanding the behaviour of consumer.
Total Utility (TU):
Total utility refers to the total satisfaction obtained from the consumption of all possible units
of a commodity. It measures the total satisfaction obtained from consumption of all the units
of that good. For example, if the 1st ice-cream gives you a satisfaction of 20 utils and 2nd one
gives 16 utils, then TU from 2 ice-creams is 20 + 16 = 36 utils. If the 3rd ice-cream generates
satisfaction of 10 utils, then TU from 3 ice-creams will be 20+ 16 + 10 = 46 utils.
TU can be calculated as:
TUn = U1 + U2 + U3 +……………………. + Un
Where: TUn = Total utility from n units of a given commodity
U1, U2, U3,……………. Un = Utility from the 1st, 2nd, 3rd nth unit
n = Number of units consumed
Marginal Utility (MU):
Marginal utility is the additional utility derived from the consumption of one more unit of the
given commodity. It is the utility derived from the last unit of a commodity purchased. As per
given example, when 3rd ice-cream is consumed, TU increases from 36 utils to 46 utils. The
additional 10 utils from the 3rd ice-cream is the MU.
In the words of Chapman, “Marginal utility is addition made to total utility by consuming one
more unit of a commodity”.
MU can be calculated as: MUn = TUn – TUn-1
Where: MUn = Marginal utility from nth unit; TUn = Total utility from n units;
TUn-1 = Total utility from n – 1 units; n = Number of units of consumption
MU of 3rd ice-cream will be: MU3 = TU3 – TU2 = 46 – 36 = 10 utils
Total Utility is Summation of Marginal Utilities:
Total utility can also be calculated as the sum of marginal utilities from all units, i.e.
TUn= MU1 + MU2 + MU3 +……………………… + MUn or simply,
TU = ∑MU
The concepts of TU and MU can be better understood from the following schedule and
diagram:
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 ™ Demand-based Pricing:
Demand-based pricing refers to a pricing method in which the price of a product is finalized
according to its demand. If the demand of a product is more, an organization prefers to set high
prices for products to gain profit; whereas, if the demand of a product is less, the low prices are
charged to attract the customers.
The success of demand-based pricing depends on the ability of marketers to analyse the
demand. This type of pricing can be seen in the hospitality and travel industries. For instance,
airlines during the period of low demand charge less rates as compared to the period of high
demand. Demand-based pricing helps the organization to earn more profit if the customers
accept the product at the price more than its cost.
™ Competition-based Pricing:
Competition-based pricing refers to a method in which an organization considers the prices of
competitors’ products to set the prices of its own products. The organization may charge higher,
lower, or equal prices as compared to the prices of its competitors.
The aviation industry is the best example of competition-based pricing where airlines charge
the same or fewer prices for same routes as charged by their competitors. In addition, the
introductory prices charged by publishing organizations for textbooks are determined
according to the competitors’ prices.
™ Other Pricing Methods:
In addition to the pricing methods, there are other methods such as
i. Value Pricing:
Implies a method in which an organization tries to win loyal customers by charging low prices
for their high- quality products. The organization aims to become a low cost producer without
sacrificing the quality. It can deliver high- quality products at low prices by improving its
research and development process. Value pricing is also called value-optimized pricing.
ii. Target Return Pricing:
Helps in achieving the required rate of return on investment done for a product. In other words,
the price of a product is fixed on the basis of expected profit.
iii. Going Rate Pricing:
Implies a method in which an organization sets the price of a product according to the
prevailing price trends in the market. Thus, the pricing strategy adopted by the organization
can be same or similar to other organizations. However, in this type of pricing, the prices set
by the market leaders are followed by all the organizations in the industry.
iv. Transfer Pricing:
Involves selling of goods and services within the departments of the organization. It is done to
manage the profit and loss ratios of different departments within the organization. One
department of an organization can sell its products to other departments at low prices.
Sometimes, transfer pricing is used to show higher profits in the organization by showing fake
sales of products within departments.
17
In practice, technical efficiency can never be more than 100%. This is mainly due to frictional
loss and incomplete combustion of fuel, which are considered to be unavoidable phenomena
in the working of a diesel engine.
ECONOMIC EFFICIENCY
Economic efficiency is the ratio of output to input of a business system.
‘Worth’ is the annual revenue generated by way of operating the business and ‘cost’ is the total
annual expenses incurred in carrying out the business. For the survival and growth of any
business, the economic efficiency should be more than 100%.
Economic efficiency is also called ‘productivity’. There are several ways of improving
productivity:
™ Increased output for the same input
™ Decreased input for the same output
™ By a proportionate increase in the output which is more than the proportionate increase
in the input
™ By a proportionate decrease in the input which is more than the proportionate decrease
in the output
™ Through simultaneous increase in the output with decrease in the input
Increased output for the same input: In this strategy, the output is increased while keeping
the input constant. Let us assume that in a steel plant, the layout of the existing facilities is not
proper. By slightly altering the location of the billet-making section, and bringing it closer to
the furnace which produces hot metal, the scale formation at the top of ladles will be
considerably reduced. The molten metal is usually carried in ladles to the billet-making section.
In the long run, this would give more yields in terms of tonnes of billet produced. In this
exercise, there is no extra cost involved. The only task is the relocation of the billet-making
facility which involves an insignificant cost.
Decreased input for the same output: In this strategy, the input is decreased to produce the
same output. Let us assume that there exists a substitute raw material to manufacture a product
and it is available at a lower price. If we can identify such a material and use it for
manufacturing the product, then certainly it will reduce the input. In this exercise, the job of
the purchase department is to identify an alternate substitute material. The process of
identification does not involve any extra cost. So, the productivity ratio will increase because
of the decreased input by way of using cheaper raw materials to produce the same output.
Less proportionate increase in output is more than that of the input: Consider the example
of introducing a new product into the existing product mix of an organization. Let us assume
that the existing facilities are not fully utilized and the R&D wing of the company has identified
a new product which has a very good market and which can be manufactured with the surplus
facilities of the organization. If the new product is taken up for production, it will lead to:
21
“Wealth in its simplest terms, is the value of all the resources that are possessed by an individual
or society”. In other words, someone’s wealth is determined by the aggregate value of
everything the person owns that can be exchanged for money, goods or services.
Individuals and countries measure wealth differently. Gross Domestic Product (GDP) is the
measure countries usually use to measure their wealth. GDP is a measure of economic output,
which is the value of all the goods and services that an economy produces in a specific period
of time. The more a country produces, the wealthier it is from a purely economic standpoint.
Individual wealth is usually measured as net worth. Which is the value of your aggregate assets
after subtracting the value of all your aggregate liabilities. If the value of your assets exceeds
the value of your liabilities, you have a positive net worth.
Characteristics of Wealth
Anything to be considered wealth should possess the following characteristics:
1. It must possess utility: That is, it must have the power to satisfy a want. As Marshall
says, ‘they must be desirable’.
2. It must be limited in supply. For example, air, sunshine are all essential for life. In fact,
man cannot live without them. They possess great utility but they are not considered
wealth because they are available in large quantities. Their supply is not limited. In other
words, there is no scarcity of those goods. Such goods are known as free goods.
3. It should be transferable. That is it must be possible for us to transfer the ownership of
such economic goods, which form wealth, from one person to another. For example, take
a house. House is wealth. For it has money value. If I pay some money to you and buy it,
I can transfer the ownership rights of house in my name.
4. It must have money value.
5. It may be external. For example, the goodwill of a business is external wealth. Certain
firms enjoy a lot of goodwill of the customers. The copyright of a book is another example
of the point that wealth is external.
6. Thus utility, scarcity and transferability are the important characteristics of wealth.
Because an economic good possesses utility and is scarce in relation to demand and is
capable of being transferred from one person to another, it has money value and so it is
considered as wealth.
Classification of Wealth
Personal Wealth (Individual Wealth)
The wealth of a person consists of both material and non-material goods. Thus the wealth of
the person includes such material things as land, houses, furniture, machinery and so on. Not
only that, if a person has some shares in companies or bonds which require others to pay money
to him, they should be included in his personal wealth. On the other hand, if he owes some debt
to others, it should be regarded as negative wealth and so subtracted from his gross wealth.
Then we get the net wealth of a person.
Social Wealth (Collective Wealth)
Social wealth consists of all these goods that can be enjoyed by all members of a society. Social
wealth includes public roads, public parks, public schools, government hospitals, public
19
According to Prof.Hidbon, “Demand means the various quantities of goods that would be
purchased per time period at different prices in a given market. Thus demand for a commodity
is its quantity which consumer is able and willing to buy at various prices during a given period
of time. Simply, demand is the behaviour of potential buyers in a market.
In the opinion of Stonier and Hague, “Demand in economics means demand backed up by
enough money to pay for the goods demanded”. In other words, demand means the desire
backed by the willingness to buy a commodity and purchasing power to pay. Hence desire
alone is not enough. There must have necessary purchasing power, i.e., .cash to purchase it.
For example, everyone desires to possess Benz car but only few have the ability to buy it. So
everybody cannot be said to have a demand for the car. Thus the demand has three essentials-
Desire, Purchasing power and Willingness to purchase.
DEMAND ANALYSIS: Demand analysis means an attempt to determine the factors affecting
the demand of a commodity or service and to measure such factors and their influences. The
demand analysis includes the study of law of demand, demand schedule, demand curve and
demand forecasting. Main objectives of demand analysis are;
1) To determine the factors affecting the demand.
2) To measure the elasticity of demand.
3) To forecast the demand.
4) To increase the demand.
5) To allocate the recourses efficiently
LAW OF DEMAND
There is an inverse relationship between quantity demanded and its price. The people know
that when price of a commodity goes up its demand comes down. When there is decrease in
price the demand for a commodity goes up. There is inverse relation between price and demand.
The law refers to the direction in which quantity demanded changes due to change in price.
A consumer may demand one dozen oranges at $5 per dozen. He may demand two dozen when
the price is $4 per dozen. A person generally buys more at a lower price. He buys less at higher
price. It is not the case with one person but all people liken to buy more due to fall in price and
vice versa. This is true for all commodities and under all conditions. The economists call it
as law of demand. In simple words the law of demand states that other things being equal more
will be demanded at lower price and lower will be demanded at higher price.
ASSUMPTIONS OF THE LAW
1. There is no change in income of consumers.
2. There is no change in the price of product.
3. There is no change in quality of product.
4. There is no substitute of the commodity.
5. The prices of related commodities remain the same.
6. There is no change in customs.
7. There is no change in taste and preference of consumers.
8. The size of population remains the same.
9. The climate and weather conditions are same.
10. The tax rates and other fiscal measures remain the same.
23
libraries, museums and so on. In short, it includes all kinds of public property and ownership.
Most of these things are called collective goods, i.e., goods that are not in private ownership.
National Wealth
National wealth includes individual wealth as well as the collective wealth of its members.
That is, it includes besides individual wealth all kinds of public property, such as roads and
canals, buildings and parks and water works.
Some writers include even free goods in the wealth of a nation. For example, Marshall
considered that even the rivers of a country should be taken into account in considering national
wealth. The Thames River in England is a free gift of nature. But he says that we must consider
the Thames a part of England’s wealth. Some writers, however, do not agree with this view.
For instance, according to Seligman, “rivers and climate do not constitute wealth. They enable
a country to acquire wealth, just as intelligence or strength enables a man to acquire wealth.
They are the source of wealth but they are not wealth”.
Further, in calculating the national wealth of a country, one should deduct the debts, which a
nation owed to other countries. Of course, we must add to the national wealth, the money or
goods that are due to us from other nations.
Cosmopolitan Wealth
Cosmopolitan wealth is the wealth of the world. It belongs to no one nation in particular. A
common example of cosmopolitan wealth is the ocean. As Marshall put it, “Just as rivers are
important elements of national wealth, the ocean is one of the most valuable properties of the
world.” Again, scientific knowledge and mechanical inventions may also be considered as
cosmopolitan wealth. For, scientific knowledge wherever discovered, soon becomes the
property of the world. So it is better to consider it as cosmopolitan wealth rather than as national
wealth. The same thing is true of mechanical inventions, for example, the mechanical
inventions that were made in England during the Industrial Revolutions soon became the
property of the world.
EFFICIENCY
Efficiency of a system is generally defined as the ratio of its output to input. The efficiency can
be classified into technical efficiency and economic efficiency.
TECHNICAL EFFICIENCY
It is the ratio of the output to input of a physical system. The physical system may be a diesel
engine, a machine working in a shop floor, a furnace, etc.
The technical efficiency of a diesel engine is as follows:
20
EXPLANATION OF THE LAW
The relationship between price of a commodity and its demand depends upon many factors.
The most important factor is nature of commodity. The demand schedule shows response of
quantity demanded to change in price of that commodity. This is the table that shows prices
per unit of commodity ands amount demanded per period of time. The demand of one person
is called individual demand. The demand of many persons is known as market demand. The
experts are concerned with market demand schedule. The market demand schedule means
'quantities of given commodity which all consumers want to buy at all possible prices at a given
moment of time'. The demand schedules of all individuals can be added up to find out market
demand schedule.
Demand schedule
Price in dollars. Demand in Kg.
5 100
4 200
3 300
2 400
The table shows the demand of all the consumers in a market. When the price decreases there
is increase in demand for goods and vice versa. When price is $5 demand is 100 kilograms.
When the price is $4 demand is 200 kilograms. Thus the table shows the total amount
demanded by all consumers various price levels.
Diagram
There is same price in the market. All consumers purchase commodity according to their needs.
The market demand curve is the total amount demanded by all consumers at different prices.
The market demand curve slopes from left down to the right.
WHY DEMAND CURVE FALLS
™ Marginal utility decreases: When a consumer buys more units of a commodity, the
marginal utility of such commodity continue to decline. The consumer can buy more
24
ƒ VALUE
Value is a broad term often used to denote cost and Price.
Value in economics is a measure of the benefit that may be gained from goods or service.
The term ‘value’ is used in different ways and, consequently, has different meanings. The
designer equates the value with reliability; a purchase person with price paid for the item; a
production person with what it costs to manufacture, and a sales person with what the customer
is willing to pay. Value, in value investigation, refers to “economic value”, which itself can be
divided into four types:
x Cost value
x Exchange value
x Use value
x Esteem value.
Cost value. It is the summation of the labour, material, overhead and all other elements of cost
required to produce an item or provide a service compared to a base.
Exchange value. It is the measure of all the properties, qualities and features of the product,
which make the product possible of being traded for another product or for money. In a
conventional sense, exchange value refers to the price that a purchaser will offer for the
product, the price being dependent upon satisfaction (value) which he derives from the product.
Use value. It is known as the function value. The use value is equal to the value of the functions
performed. Therefore, it is the price paid by the buyer (buyer’s view), or the cost incurred by
the manufacturer (manufacturer’s view) in order to ensure that the product performs its
intended functions efficiently. The use value is the fundamental form of economic value. An
item without “use value” can have neither “exchange value” nor “esteem value”.
Esteem value. It involves the qualities and appearance of a product (like a TV set), which
attract persons and create in them a desire to possess the product. Therefore, esteem value is
the price paid by the buyer or the cost incurred by the manufacturer beyond the use value.
ƒ WEALTH
Total of all assets of an economic unit that generate current income or have the potential to
generate future income. It includes natural resources and human capital but generally
excludes money and securities because they represent only claims to wealth.
Two common types of economic wealth are
(1) Monetary wealth: anything that can be bought and sold, for which there is market and
hence a price.
(2) Non-monetary wealth: things which depend on scarce resources, and for which there
is demand, but are not bought and sold in a market and hence have no
price. Examples are education, health, and defence.
18
™ an increase in the revenue of the organization by way of selling the new product in
addition to the existing product mix and Engineering Economics
™ An increase in the material cost and operation and maintenance cost of machineries
because of producing the new product.
If we examine these two increases closely, the proportionate increase in the revenue will be
more than the proportionate increase in the input cost. Hence, there will be a net increase in the
productivity ratio.
When proportionate decrease in input is more than that of the output: Let us consider the
converse of the previous example, i.e. dropping an uneconomical product from the existing
product mix. This will result in the following:
™ A decrease in the revenue of the organization
™ A decrease in the material cost, and operation and maintenance cost of machinery
If we closely examine these two decreases, we will see that the proportionate decrease in the
input cost will be more than the proportionate decrease in the revenue. Hence, there will be a
net increase in the productivity ratio.
Simultaneous increase in output and decrease in input: Let us assume that there are
advanced automated technologies like robots and automated guided vehicle system (AGVS),
available in the market which can be employed in the organization we are interested in. If we
employ these modern tools, then:
™ There will be a drastic reduction in the operation cost. Initially, the cost on equipment
would be very high. But, in the long run, the reduction in the operation cost would
break-even the high initial investment and offer more savings on the input.
™ These advanced facilities would help in producing more products because they do not
experience fatigue. The increased production will yield more revenue.
In this example, in the long run, there is an increase in the revenue and a decrease in the input.
Hence, the productivity ratio will increase at a faster rate.
DEMAND
Demand refers to how much (quantity) of a product or service is desired by buyers. The
quantity demanded is the amount of a product people are willing to buy at a certain price; the
relationship between price and quantity demanded is known as the demand relationship.
DEFINITION OF 'DEMAND' An economic principle that describes a consumer's desire and
willingness to pay a price for a specific good or service. Holding all other factors constant, the
price of a good or service increases as its demand increases and vice versa.
Demand is a common parlance means desire for an object. But in economics demand is
something more than this. In economics „Demand‟ means the quantity of goods and services
which a person can purchase with a requisite amount of money.
22
 units of commodity when its price falls and vice versa. The demand curve falls because
demand is more at lower price.
™ Price effect: When there is increase in price of commodity, the consumers reduce the
consumption of such commodity. The result is that there is decrease in demand for that
commodity. The consumers consume mo0re or less of a commodity due to price effect.
The demand curve slopes downward.
™ Income effect: Real income of consumer rises due to fall in prices. The consumer can
buy more quantity of same commodity. When there is increase in price, real income of
consumer falls. This is income effect that the consumer can spend increased income on
other commodities. The demand curve slopes downward due to positive income effect.
™ Same price of substitutes: When the price of a commodity falls, the prices of
substitutes remaining the same, consumer can buy more of the commodity and vice
versa. The demand curve slopes downward due to substitution effect.
™ Demand of poor people: The income of people is not the same, the rich people have
money to buy same commodity at high prices. Large majority of people are poor, they
buy more when price fall and vice versa. The demand curve slopes due to poor people.
™ Different uses of goods: There are different uses of many goods. When prices of such
goods increase these goods are put into uses that are more important and their demand
falls. The demand curve slopes downward due to such goods.
IMPORTANCE OF THE LAW
Price determination: A monopolist can determine price of a commodity on the basis of such
law. He can know the effect on demand due to increase or decrease in price. The demand
schedule can help him to determine the most suitable price level.
Tax on commodities: The law of demand is important for tax authorities. The effect of tax on
different commodities is checked. The commodity must be taxed if its demand is relatively
inelastic. A commodity cannot be taxed if its sales fall to great extent.
Agricultural prices: The law of demand is useful to determine agricultural prices. When there
are good crops, the prices come down due to change in demand. In case of bad crops, the prices
go up if demand remains the same. The poverty of farmers can be determined.
Planning: Individual demand schedule is used in planning for individual goods and industries.
There is need to know the effect of change in price on the demand of commodity at national
and world level. The nature of demand schedule helps to know such effect.
EXCEPTIONS TO THE LAW
Inferior goods: The law of demand does not apply in case of inferior goods. When price of
inferior commodity decreases and its demand also decrease and amount so saved in spent on
superior commodity. The wheat and rice are superior food grains while maize is inferior food
grain.
Demonstration effect: The law of demand does not apply in case of diamond and jewellery.
There is more demand when prices are high. There is less demand due to low prices. The rich
people like to demonstrate such items that only they have such commodities.
25
DIFFERENT TYPES OF DEMAND.
™ Joint demand: When two or more commodities are jointly demanded at the same time
to satisfy a particular want, it is called joint or complimentary demand. (Demand for
milk, sugar, tea for making tea).
™ Composite demand: The demand for a commodity which can be put for several uses
(demand for electricity)
™ Direct and Derived demand: Demand for a commodity which is for a direct
consumption is called direct demand. (Food, cloth). When the commodity is demanded
as a result of the demand of another commodity, it is called derived demand. (Demand
for tyres depends on demand of vehicles).
™ Industry demand and company demand: Demand for the product of particular
company is company demand and total demand for the products of particular industry
which includes number of companies is called industry demand
ELASTICITY OF DEMAND
Law of demand explains the directions of changes in demand. A fall in price leads to an increase
in quantity demanded and vice versa. But it does not tell us the rate at which demand changes
to change in price. The concept of elasticity of demand was introduced by Marshall. This
concept explains the relationship between a change in price and consequent change in quantity
demanded. Nutshell, it shows the rate at which changes in demand take place.
Elasticity of demand can be defined as “the degree of responsiveness in quantity demanded to
a change in price”. Thus it represents the rate of change in quantity demanded due to a change
in price. There are mainly three types of elasticity of demand:
1. Price Elasticity of Demand.
2. Income Elasticity of Demand. And
3. Cross Elasticity of Demand.
Price Elasticity of Demand
Price Elasticity of demand measures the change in quantity demanded to a change in price. It
is the ratio of percentage change in quantity demanded to a percentage change in price. This
can be measured by the following formula.
Where: Q1 = Quantity demanded before price change
Q2 = Quantity demanded after price change
P1 = Price charged before price change
P2 = Price charge after price change.
29
complementary goods changes simultaneously. The complementary goods are inversely related
to each other. For example, increase in the prices of petrol would decrease the demand of cars.
v. Expectations of Consumers: Imply that expectations of consumers about future changes in
the price of a product affect the demand for that product in the short run. For example, if
consumers expect that the prices of petrol would rise in the next week, then the demand of
petrol would increase in the present.
On the other hand, consumers would delay the purchase of products whose prices are expected
to be decreased in future, especially in case of non-essential products. Apart from this, if
consumers anticipate an increase in their income, this would result in increase in demand for
certain products. Moreover, the scarcity of specific products in future would also lead to
increase in their demand in present.
vi. Effect of Advertisements: Refers to one of the important factors of determining the demand
for a product. Effective advertisements are helpful in many ways, such as catching the attention
of consumers, informing them about the availability of a product, demonstrating the features
of the product to potential consumers, and persuading them to purchase the product. Consumers
are highly sensitive about advertisements as sometimes they get attached to advertisements
endorsed by their favourite celebrities. This results in the increase demand for a product.
vii. Distribution of Income in the Society: Influences the demand for a product in the market
to a large extent. If income is equally distributed among people in the society, the demand for
products would be higher than in case of unequal distribution of income. However, the
distribution of income in the society varies widely.This leads to the high or low consumption
of a product by different segments of the society.
viii. Growth of Population: Acts as a crucial factor that affect the market demand of a product.
If the number of consumers increases in the market, the consumption capacity of consumers
would also increase. Therefore, high growth of population would result in the increase in the
demand for different products.
ix. Government Policy: Refers to one of the major factors that affect the demand for a product.
For example, if a product has high tax rate, this would increase the price of the product. This
would result in the decrease in demand for a product. Similarly, the credit policies of a country
also induce the demand for a product. For example, if sufficient amount of credit is available
to consumers, this would increase the demand for products.
x. Climatic Conditions: Affect the demand of a product to a greater extent. For example, the
demand of ice-creams and cold drinks increases in summer, while tea and coffee are preferred
in winter. Some products have a stronger demand in hilly areas than in plains. Therefore,
individuals demand different products in different climatic conditions.
DEMAND FUNCTION. : There is a functional relationship between demand and its various
determinants. I.e., a change in any determinant will affect the demand. When this relationship
expressed mathematically, it is called Demand Function. Demand function of a commodity can
be written as: D = f (P, Y, T, Ps, U)
Where, D= Quantity demanded P= Price of the commodity
Y= Income of the consumer T= Taste and preference of consumers.
Ps = Price of substitutes U= Consumers expectations & others
f = Function of (indicates how variables are related)
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5) Unit elasticity of demand (unitary elastic) : Here the change in demand is exactly equal
to the change in price. When both are equal, ep= 1, the elasticity is said to be unitary.
The above five types of elasticity can be summarized as follows
Income elasticity of demand
Income elasticity of demand is the degree of responsiveness of demand to the change in income.
ey = Percentage change in quantity demanded
Percentage change in income
CROSS ELASTICITY OF DEMAND
Cross elasticity of demand is the proportionate change in the quantity demanded of a
commodity in response to change in the price of another related commodity. Related
commodity may either substitutes or complements. Examples of substitute commodities are
tea and coffee. Examples of compliment commodities are car and petrol. Cross elasticity of
demand can be calculated by the following formula;
Cross Elasticity = Proportionate Change in Quantity Demanded of a Commodity
Proportionate Change in the Price of Related Commodity
If the cross elasticity is positive, the commodities are said to be substitutes and if cross elasticity
is negative, the commodities are compliments. The substitute goods (tea and Coffee) have
positive cross elasticity because the increase in the price of tea may increase the demand of the
coffee and the consumer may shift from the consumption of tea to coffee.
Complementary goods (car and petrol) have negative cross elasticity because increase in the
price of car will reduce the quantity demanded of petrol.
The concept of cross elasticity assists the manager in the process of decision making. For fixing
the price of product which having close substitutes or compliments, cross elasticity is very
useful.
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EXTENSION AND CONTRACTION OF DEMAND.
Demand may change due to various factors. The change in demand due to change in price only,
where other factors remaining constant, it is called extension and contraction of demand. A
change in demand solely due to change in price is called extension and contraction. When the
quantity demanded of a commodity rises due to a fall in price, it is called extension of demand.
On the other hand, when the quantity demanded falls due to a rise in price, it is called
contraction of demand. It can be understand from the following diagram.
When the price of commodity is OP, quantity demanded is OQ. If the price falls to P2, quantity
demanded increases to OQ2. When price rises to P1, demand decreases from OQ to OQ1. In
demand curve, the area a to c is extension of demand and the area a to b is contraction of
demand. As result of change in price of a commodity, the consumer moves along the same
demand curve.
SHIFT IN DEMAND (INCREASE OR DECREASE IN DEMAND)
When the demand changes due to changes in other factors, like taste and preferences, income,
price of related goods etc... , it is called shift in demand. Due to changes in other factors, if the
consumers buy more goods, it is called increase in demand or upward shift. On the other hand,
if the consumers buy fewer goods due to change in other factors, it is called downward shift or
decrease in demand. Shift in demand cannot be shown in same demand curve. The increase
and decrease in demand (upward shift and downward shift) can be expressed by the following
diagram
DD is the original demand curve. Demand curve shift upward due to change in income, taste
& preferences etc. of consumer, where price remaining the same. In the above diagram demand
curve D1- D1 is showing upward shift or increase in demand and D2-D2 shows downward
shift or decrease in demand.
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DETERMINANTS OF ELASTICITY.
Elasticity of demand varies from product to product, time to time and market to market. This
is due to influence of various factors. They are:
1. Nature of commodity- Demand for necessary goods (salt, rice, etc.,) is inelastic. Demand
for comfort and luxury good are elastic.
2. Availability/range of substitutes – A commodity against which lot of substitutes are
available, the demand for that is elastic. But the goods which have no substitutes, demand is
inelastic.
3. Extent /variety of uses- a commodity having a variety of uses have a comparatively elastic
demand. Eg. Demand for steel, electricity etc.
4. Postponement/urgency of demand- if the consumption of a commodity can be post pond,
then it will have elastic demand. Urgent commodity has inelastic demand.
5. Income level- income level also influences the elasticity. E.g. Rich man will not curtail the
consumption quantity of fruit, milk etc., even if their price rises, but a poor man will not follow
it.
6. Amount of money spend on the commodity- where an individual spends only a small
portion of his income on the commodity, the price change doesn’t materially affect the demand
for the commodity, and the demand is inelastic... (Match box, salt Etc.)
7. Durability of commodity- if the commodity is durable or repairable at a substantially less
amount (eg.Shoes), the demand for that is elastic.
8. Purchase frequency of a product/time –if the frequency of purchase of a product is very
high, the demand is likely to be more price elastic.
9. Range of Prices- if the products at very high price or at very low price having inelastic
demand since a slight change in price will not affect the quantity demand.
10. Others – the habit of consumers, demand for complimentary goods, distribution of income
and wealth in the society etc., are other important factors affecting elasticity.
SUPPLY
The total amount of a product (good or service) available for purchase at any specified price.
Supply is determined by: (1) Price: producers will try to obtain the highest possible price
whereas the buyers will try to pay the lowest possible price both settling at the equilibrium
price where supply equals demand. (2) Cost of inputs: the lower the input price the higher
the profit at a price level and more products will be offered at that price. (3) Price of
other goods: lower prices of competing goods will reduce the price and
the supplier may switch to switch to more profitable products thus reducing the supply.
x Supply is defined as the total quantity of a product or service that the marketplace can
offer. The quantity supplied is the amount of a product/service that suppliers are
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Ignorance of consumers: The consumer usually judge the quality of a commodity from its
price. A low priced commodity is considered as inferior and less quantity is purchased. A high
priced commodity is treated as superior and more quantity is purchased. The law of demand
does not apply in this case.
Less supply: The law of demand does not work when there is less supply of commodity. The
people buy more for stock purpose even at high price. They think that commodity will become
short.
Depression: The law of demand does not work during period of depression. The prices of
commodities are low but there is increase in demand. It is due to low purchasing power of
people.
Speculation: The law does not apply in case of speculation. The speculators start buying share
just to raise the price. Then they start selling large quantity of shares to avoid losses.
Out of fashion: The law of demand is not applicable in case of goods out of fashion. The
decrease in prices cannot raise the demand of such goods. The quantity purchased is less even
though there is falls in prices.
DETERMINANTS OF DEMAND FOR A PRODUCT
i. Price of a Product or Service: Affects the demand of a product to a large extent. There is
an inverse relationship between the price of a product and quantity demanded. The demand for
a product decreases with increase in its price, while other factors are constant, and vice versa.
ii. Income: Constitutes one of the important determinants of demand. The income of a
consumer affects his/her purchasing power, which, in turn, influences the demand for a product.
Increase in the income of a consumer would automatically increase the demand for products
by him/her, while other factors are at constant, and vice versa
iii. Tastes and Preferences of Consumers: Play a major role in influencing the individual and
market demand of a product. The tastes and preferences of consumers are affected due to
various factors, such as life styles, customs, common habits, and change in fashion, standard
of living, religious values, age, and gender. A change in any of these factors leads to change in
the tastes and preferences of consumers. Consequently, consumers reduce the consumption of
old products and add new products for their consumption.
iv. Price of Related Goods: Refer to the fact that the demand for a specific product is
influenced by the price of related goods to a greater extent. Related goods can be of two types,
namely, substitutes and complementary goods, which are explained as follows:
a. Substitutes: Refer to goods that satisfy the same need of consumers but at a different price.
For example, tea and coffee, jowar and bajra, and groundnut oil and sunflower oil are substitute
to each other. The increase in the price of a good results in increase in the demand of its
substitute with low price. Therefore, consumers usually prefer to purchase a substitute, if the
price of a particular good gets increased.
b. Complementary Goods: Refer to goods that are consumed simultaneously or in
combination. In other words, complementary goods are consumed together. For example, pen
and ink, car and petrol, and tea and sugar are used together. Therefore, the demand for
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Types of price elasticity of demand. (Degree of elasticity of demand)
1) Perfectly elastic demand (infinitely elastic): When a small change in price leads to infinite
change in quantity demanded, it is called perfectly elastic demand. In this case the demand
curve is a horizontal straight line as given below. (Here ep= ∞)
2) Perfectly inelastic demand: In this case, even a large change in price fails to bring about a
change in quantity demanded. I.e. the change in price will not affect the quantity demanded
and quantity remains the same whatever the change in price. Here demand curve will be vertical
line as follows and ep= 0
3) Relatively elastic demand: Here a small change in price leads to very big change in quantity
demanded. In this case demand curve will be fatter one and ep=>1
4) Relatively inelastic demand : Here quantity demanded changes less than proportionate to
changes in price. A large change in price leads to small change in demand. In this case demand
curve will be steeper and ep=<1
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 willing to supply at a given price. This relationship between price and the amount of a
good/service supplied is known as the supply relationship.
x Supply means the goods offered for sale at a price during a specific period of time. It is
the capacity and intention of the producers to produce goods and services for sale at a
specific price.
x The supply of a commodity at a given price may be defined as the amount of it which
is actually offered for sale per unit of time at that price.
THE LAW OF SUPPLY
The law of supply states:
Other things remaining the same, the higher the price of a good, the greater is the quantity
supplied; and the lower the price of a good, the smaller is the quantity supplied.
The law of supply results from the general tendency for the marginal cost of producing a good
or service to increase as the quantity produced increases. Producers are willing to supply a good
only if they can at least cover their marginal cost of production.
The law of supply establishes a direct relationship between price and supply. Firms will supply
less at lower prices and more at higher prices. “Other things remaining the same, as the price
of commodity rises, its supply expands and as the price falls, its supply contracts”.
SUPPLY SCHEDULE AND SUPPLY CURVE
A supply schedule is a statement of the various quantities of a given commodity offered for
sale at various prices per unit of time. With the help of the supply schedule, a supply curve can
be drawn.
Individual supply schedule and curve
Individual supply schedule is a list of prices and quantities of a given commodity offered for
sale by an individual seller or producer.
It is seen that when the price is Rs.4 three dozen are offered for sale. As the price increases, the
quantity supplied also increases.
With the help of the supply schedule, we can construct supply curve. On the basis of the
schedule, supply curve SS is drawn.
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Surplus and shortage:
If the market price is above the equilibrium price, quantity supplied is greater than quantity
demanded, creating a surplus. Market price will fall. Example: if you are the producer, you
have a lot of excess inventory that cannot sell. Will you put them on sale? It is most likely yes.
Once you lower the price of your product, your product’s quantity demanded will rise until
equilibrium is reached. Therefore, surplus drives price down.
If the market price is below the equilibrium price, quantity supplied is less than quantity
demanded, creating a shortage. The market is not clear. It is in shortage. Market price will rise
because of this shortage. Example: if you are the producer, your product is always out of stock.
Will you raise the price to make more profit? Most for-profit firms will say yes. Once you raise
the price of your product, your product’s quantity demanded will drop until equilibrium is
reached. Therefore, shortage drives price up.
Demand and supply determine the market equilibrium. At market equilibrium the quantity the
consumers freely and willingly demand at the market price is exactly equal to the quantity that
producers freely and willingly bring to market at that price. There is neither excess demand
(shortage) nor excess supply (glut) on the market.
What is bought in a market must be equal to what is sold. This is a truism that must hold.
Market equilibrium means more than that. It indicates that the amount consumers want to buy
at the market price is exactly equal to what producers want to sell at the same market price.
It is important to understand the concept of market equilibrium in economics. Equilibrium is
neither intrinsically good nor bad. Equilibrium exists when opposing forces just offset each
other. Consequently, if an economy or a market is at equilibrium it will tend to stay there. Thus
it means that if the system or market is in disequilibrium there are forces that tend to push it
back to equilibrium.
MARKETS (Perfect Competition, Monopoly and Monopolistic competition)
The term “market” refers to a particular place where goods are purchased and sold. But,
in economics, market is used in a wide perspective. In economics, the term “market” does not
mean a particular place but the whole area where the buyers and sellers of a product are spread.
This is because in the present age the sale and purchase of goods are with the help of agents
and samples. Hence, the sellers and buyers of a particular commodity are spread over a large
area. The transactions for commodities may be also through letters, telegrams, telephones,
internet, etc. Thus, market in economics does not refer to a particular market place but the
entire region in which goods are bought and sold. In these transactions, the price of a
commodity is the same in the whole market. According to Prof. R. Chapman, “The term
market refers not necessarily to a place but always to a commodity and the buyers and
sellers who are in direct competition with one another.”
Characteristics of Market:
(1) An Area: In economics, a market does not mean a particular place but the whole region
where sellers and buyers of a product ate spread. Modem modes of communication and
transport have made the market area for a product very wide.
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FACTORS DETERMINING SUPPLY
1. Production technology: State of production technology affects the supply function. If
advanced technology is used in the country, large scale production is possible. Hence supply
will increase. Old technology will not increase the supply.
2. Prices of factors: When the prices of factors rise, cost of production will increase. This will
result in a decrease in supply.
3. Prices of other products: Any change in the prices of other products will influence the
supply. An increase in the price of other products will influence the producer to shift the
production in favour of that product. Supply of the original product will be reduced.
4. Number of producers or firms: If the number of producers producing the product
increases, the supply of the product will increase in the market.
5. Future price expectations: If producers expect that there will be a rise in the prices of
products in future, they will not supply their products at present.
6. Taxes and subsidies: If tax is imposed by the government on the inputs of a commodity,
cost of production will go up. Supply will be reduced. When subsidy is given to the producer,
it will encourage them to produce and supply more. Subsidy means a part of the cost of a
commodity will be borne by the government.
7. Non-economic factors: Non-economic factors like, war, political climate and natural
calamities create scarcity in supply
ELASTICITY OF SUPPLY
The law of supply tells us that quantity supplied will respond to a change in price. The concept
of elasticity of supply explains the rate of change in supply as a result of change in price. It is
measured by the formula mentioned below:
Elasticity of supply = Proportionate change in quantity supplied
Proportionate change in price
Elasticity of supply may be defined as “the degree of responsiveness of change in supply to
change in price on the part of sellers”.
TYPES OF ELASTICITY OF SUPPLY
There are five types of elasticity of supply.
1. Perfectly elastic supply: The coefficient of elasticity of supply is infinity. (eS is ∞). For a
small change or no change in price, there will be infinite amount of supply. (SS1 in Figure)
2. Relatively elastic supply: The coefficient of elastic supply is greater than 1(es > 1). Quantity
supplied changes by a larger percentage than price. (SS2 in figure)
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PERFECT COMPETITION MARKET:
A perfectly competitive market is one in which the number of buyers and sellers is very large,
all engaged in buying and selling a homogeneous product without any artificial restrictions and
possessing perfect knowledge of market at a time. In the words of A. Koutsoyiannis, “Perfect
competition is a market structure characterised by a complete absence of rivalry among the
individual firms.” According to R.G. Lipsey, “Perfect competition is a market structure in
which all firms in an industry are price- takers and in which there is freedom of entry into, and
exit from, industry.”
Characteristics of Perfect Competition:
(1) Large Number of Buyers and Sellers:
The first condition is that the number of buyers and sellers must be so large that none of them
individually is in a position to influence the price and output of the industry as a whole. The
demand of individual buyer relative to the total demand is so small that he cannot influence the
price of the product by his individual action.
Similarly, the supply of an individual seller is so small a fraction of the total output that he
cannot influence the price of the product by his action alone. In other words, the individual
seller is unable to influence the price of the product by increasing or decreasing its supply.
Thus no buyer or seller can alter the price by his individual action. He has to accept the price
for the product as fixed for the whole industry. He is a “price taker”.
(2) Freedom of Entry or Exit of Firms: The next condition is that the firms should be free to
enter or leave the industry. It implies that whenever the industry is earning excess profits,
attracted by these profits some new firms enter the industry. In case of loss being sustained by
the industry, some firms leave it.
(3) Homogeneous Product: Each firm produces and sells a homogeneous product so that no
buyer has any preference for the product of any individual seller over others. This is only
possible if units of the same product produced by different sellers are perfect substitutes. In
other words, the cross elasticity of the products of sellers is infinite. No seller has an
independent price policy. Commodities like salt, wheat, cotton and coal are homogeneous in
nature. He cannot raise the price of his product. If he does so, his customers would leave him
and buy the product from other sellers at the ruling lower price.
(4) Absence of Artificial Restrictions: The next condition is that there is complete openness
in buying and selling of goods. Sellers are free to sell their goods to any buyers and the buyers
are free to buy from any sellers. In other words, there is no discrimination on the part of buyers
or sellers. Moreover, prices are liable to change freely in response to demand-supply
conditions. There are no efforts on the part of the producers, the government and other agencies
to control the supply, demand or price of the products. The movement of prices is unfettered.
(5) Profit Maximisation Goal: Every firm has only one goal of maximising its profits.
(6) Perfect Mobility of Goods and Factors: Another requirement of perfect competition is
the perfect mobility of goods and factors between industries. Goods are free to move to those
places where they can fetch the highest price. Factors can also move from a low-paid to a high-
paid industry.
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3. Unitary elastic supply: The coefficient of elastic supply is equal to 1 (es = 1). A change in
price will cause a proportionate change in quantity supplied. (SS3 in figure)
4. Relatively inelastic supply: The coefficient of elasticity is less than one (es < 1). Quantity
supplied changes by a smaller percentage than price. (SS4 in figure)
5. Perfectly inelastic supply: The coefficient of elasticity is equal to zero (es = 0). A change
in price will not bring about any change in quantity supplied. (SS5 in figure)
FACTORS DETERMINING ELASTICITY OF SUPPLY
The following factors will influence the elasticity of supply
1. Changes in cost of production
2. Behaviour pattern of producers
3. Availability of facilities for expanding output.
4. Supply in the short and long period.
MARKET EQUILIBRIUM
When the supply and demand curves intersect, the market is in equilibrium. This is where the
quantity demanded and quantity supplied is equal. The corresponding price is the equilibrium
price or market-clearing price, the quantity is the equilibrium quantity.
Market equilibrium is one of the most important concepts in the study of economics. Market
equilibrium is a situation in which the supply of an item is exactly equal to its demand. Since
there is neither surplus nor shortage in the market, price tends to remain stable in this situation.
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(7) Perfect Knowledge of Market Conditions: This condition implies a close contact between
buyers and sellers. Buyers and sellers possess complete knowledge about the prices at which
goods are being bought and sold, and of the prices at which others are prepared to buy and sell.
They have also perfect knowledge of the place where the transactions are being carried on.
Such perfect knowledge of market conditions forces the sellers to sell their product at the
prevailing market price and the buyers to buy at that price.
(8) Absence of Transport Costs: Another condition is that there are no transport costs in
carrying of product from one place to another. This condition is essential for the existence of
perfect competition which requires that a commodity must have the same price everywhere at
any time. If transport costs are added to the price of the product, even a homogeneous
commodity will have different prices depending upon transport costs from the place of supply.
(9) Absence of Selling Costs: Under perfect competition, the costs of advertising, sales-
promotion, etc. do not arise because all firms produce a homogeneous product.
MONOPOLY MARKET
Monopoly is a market situation in which there is only one seller of a product with barriers to
entry of others. The product has no close substitutes. The cross elasticity of demand with every
other product is very low. This means that no other firms produce a similar product. According
to D. Salvatore, “Monopoly is the form of market organisation in which there is a single firm
selling a commodity for which there are no close substitutes.” Thus the monopoly firm is itself
an industry and the monopolist faces the industry demand curve.
The demand curve for his product is, therefore, relatively stable and slopes downward to the
right, given the tastes, and incomes of his customers. It means that more of the product can be
sold at a lower price than at a higher price. He is a price-maker who can set the price to his
maximum advantage.
However, it does not mean that he can set both price and output. He can do either of the two
things. His price is determined by his demand curve, once he selects his output level. Or, once
he sets the price for his product, his output is determined by what consumers will take at that
price. In any situation, the ultimate aim of the monopolist is to have maximum profits.
Characteristics of Monopoly:
1. Under monopoly, there is one producer or seller of a particular product and there is no differ-
ence between a firm and an industry. Under monopoly a firm itself is an industry.
2. A monopoly may be individual proprietorship or partnership or Joint Stock Company or a
cooperative society or a government company.
3. A monopolist has full control on the supply of a product. Hence, the elasticity of demand for
a monopolist’s product is zero.
4. There is no close substitute of a monopolist’s product in the market. Hence, under monopoly,
the cross elasticity of demand for a monopoly product with some other good is very low.
5. There are restrictions on the entry of other firms in the area of monopoly product.
6. A monopolist can influence the price of a product. He is a price-maker, not a price-taker.
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Market supply schedule and curve
By adding up the quantity supplied at various prices by all sellers in the market, we can get
market supply schedule.
Market supply curve is the lateral summation of the individual supply curves of all the
producers in the market.
Movement along the supply curve or expansion and contraction of supply curve
When more units are supplied at a higher price, it is called ‘expansion of supply’. When fewer
units are supplied at a lower price, it is called ‘contraction in supply’. It is illustrated in
following figure
When the price is OP, OA is supplied. When price increases to OP1, the producer will supply
OB units. The movement from OA to OB shows the expansion in supply. Original price is OP
and original supply is OA. When price falls to OP2 the producer will supply OC units. The
supply has contracted from OA to OC.
Shifts in supply (or) increase or decrease in supply
Increase or decrease in supply causes shifts in the supply curve. A shift in the supply curve is
due to a change in other factors i.e., other than the price of the commodity. It is explained in
the below figure
At price OP, SS is the supply curve before the change in other factors. S1 S1 shows an increase
in supply because at the same price OP or TE more is offered for sale i.e. OT1.
S2 S2 shows decrease in supply because at the same price OP or TE, less is offered for sale i.e.
OT2.
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(2) One Commodity: In economics, a market is not related to a place but to a particular
product. Hence, there are separate markets for various commodities. For example, there are
separate markets for clothes, grains, jewellery, etc.
(3) Buyers and Sellers:
The presence of buyers and sellers is necessary for the sale and purchase of a product in the
market. In the modem age, the presence of buyers and sellers is not necessary in the market
because they can do transactions of goods through letters, telephones, business representatives,
internet, etc.
(4) Free Competition: There should be free competition among buyers and sellers in the
market. This competition is in relation to the price determination of a product among buyers
and sellers.
(5) One Price: The price of a product is the same in the market because of free competition
among buyers and sellers.
On the basis of above elements of a market, its general definition may be as follows:
The market for a product refers to the whole region where buyers and sellers of that
product are spread and there is such free competition that one price for the product
prevails in the entire region.
MARKET STRUCTURE
Market structure refers to the nature and degree of competition in the market for goods and
services. The structures of market both for goods market and service (factor) market are
determined by the nature of competition prevailing in a particular market.
Determinants:
1. The number and nature of sellers.
2. The number and nature of buyers.
3. The nature of the product.
4. The conditions of entry into and exit from the market.
5. Economies of scale.
Forms of Market Structure:
On the basis of competition, a market can be classified in the following ways:
1. Perfect Competition
2. Monopoly
3. Duopoly
4. Oligopoly
5. Monopolistic Competition
38
7. Pure monopoly is not found in the real world.
8. Monopolist cannot determine both the price and quantity of a product simultaneously.
9. Monopolist’s demand curve slopes downwards to the right. That is why, a monopolist can
increase his sales only by decreasing the price of his product and thereby maximise his profit.
The marginal revenue curve of a monopolist is below the average revenue curve and it falls
faster than the average revenue curve. This is because a monopolist has to cut down the price
of his product to sell an additional unit.
(5) Independent Behaviour: In monopolistic competition, every firm has independent policy.
Since the number of sellers is large, none controls a major portion of the total output. No seller
by changing its price-output policy can have any perceptible effect on the sales of others and
in turn be influenced by them.
(6) Product Groups: There is no any ‘industry’ under monopolistic competition but a ‘group’
of firms producing similar products. Each firm produces a distinct product and is itself an
industry. Chamberlin lumps together firms producing very closely related products and calls
them product groups, such as cars, cigarettes, etc.

DUOPOLY
Duopoly is a special case of the theory of oligopoly in which there are only two sellers. Both
the sellers are completely independent and no agreement exists between them. Even though
they are independent, a change in the price and output of one will affect the other, and may set
a chain of reactions. A seller may, however, assume that his rival is unaffected by what he does,
in that case he takes only his own direct influence on the price. If, on the other hand, each seller
takes into account the effect of his policy on that of his rival and the reaction of the rival on
himself again, then he considers both the direct and the indirect influences upon the price.
Moreover, a rival seller’s policy may remain unaltered either to the amount offered for sale or
to the price at which he offers his product. Thus the duopoly problem can be considered as
either ignoring mutual dependence or recognising it.
(7) Selling Costs: Under monopolistic competition where the product is differentiated, selling
costs are essential to push up the sales. Besides, advertisement, it includes expenses on
salesman, allowances to sellers for window displays, free service, free sampling, premium
coupons and gifts, etc.
(8) Non-price Competition: Under monopolistic competition, a firm increases sales and
profits of his product without a cut in the price. The monopolistic competitor can change his
product either by varying its quality, packing, etc. or by changing promotional programmes.
The features of market structures are shown in Table

OLIGOPOLY
Oligopoly is a market situation in which there are a few firms selling homogeneous or
differentiated products. It is difficult to pinpoint the number of firms in ‘competition among
the few.’ With only a few firms in the market, the action of one firm is likely to affect the
others. An oligopoly industry produces either a homogeneous product or heterogeneous
products.

The former is called pure or perfect oligopoly and the latter is called imperfect or differentiated
oligopoly. Pure oligopoly is found primarily among producers of such industrial products as
aluminium, cement, copper, steel, zinc, etc. Imperfect oligopoly is found among producers of
such consumer goods as automobiles, cigarettes, soaps and detergents, TVs, rubber tyres,
refrigerators, typewriters, etc.

Characteristics of Oligopoly:
(1) Interdependence: There is recognised interdependence among the sellers in the
oligopolistic market. Each oligopolist firm knows that changes in its price, advertising, product
characteristics, etc. may lead to counter-moves by rivals. When the sellers are a few, each
produces a considerable fraction of the total output of the industry and can have a noticeable MONEY
effect on market conditions. Anything of value that serves as a (1) generally accepted medium of financial exchange,
(2) Advertisement: The main reason for this mutual interdependence in decision making is (2) legal tender for repayment of debt, (3) standard of value, (4) unit of accounting measure,
that one producer’s fortunes are dependent on the policies and fortunes of the other producers and(5) means to save or store purchasing power.
in the industry. It is for this reason that oligopolist firms spend much on advertisement and
customer services. FUNCTIONS OF MONEY
(3) Competition: This leads to another feature of the oligopolistic market, the presence of
competition. Since under oligopoly, there are a few sellers, a move by one seller immediately (a) Primary functions, which include the medium of exchange and the measure of value;
affects the rivals. So each seller is always on the alert and keeps a close watch over the moves
of its rivals in order to have a counter-move. This is true competition.

41 43

securities is made possible by money. By acting as a standard of deferred payments, money
helps in capital formation both by the government and business enterprises. In fine, this
function of money develops financial and capital markets and helps in the growth of the
economy.
(ii) Money as a Store of Value:
Another important function of money is that it acts as a store of value. “The good chosen as
money is always something which can be kept for long periods without deterioration or
wastage. It is a form in which wealth can be kept intact from one year to the next. Money is a
bridge from the present to the future. It is therefore essential that the money commodity should
always be one which can be easily and safely stored.” Money as a store of value is meant to
meet unforeseen emergencies and to pay debts.
(iii) Money as a Transfer of Value: Since money is a generally acceptable means of payment
and acts as a store of value, it keeps on transferring values from person to person and place to
place. A person who holds money in cash or assets can transfer that to any other person.
Moreover, he can sell his assets at Delhi and purchase fresh assets at Bangalore. Thus money
facilitates transfer of value between persons and places.
providing a basis for credit, come under the category of dynamic functions, for these bring
about changes in the level and nature of economic activities. Monetary measures are formulated
only with a view to perform dynamic functions of money.
The dynamic functions are those by which money actively influences the economic system
through its impact on price level, interest rates, volume of production, distribution of wealth
and income etc. In its dynamic role, money tends to influence the economic trends. Important
dynamic functions of money are described below:
(i) Effect on Price Level: Money has great influence on the economic activity through a rise
or fall in the price level (or a fall or rise in the value of money.) According to one explanation,
inflation or a general rise in price level is caused by an increase in the amount of money in
circulation; and deflation or a general fall in price level is due to decrease in money supply.
(ii) Effect on Interest Rate: Money has great influence on the economic system by changing
interest rates. Change in the money supply is partially responsible for the fluctuations in the
interest rates. Interest rate falls with an increase in money supply and rises with a decrease in
money supply.

(iii) Effect on Utilisation of Resources: Proper application of monetary system can bring
3. Contingent Functions:
about an efficient and full utilisation of natural and human resources of the country and of its
(i) Money as the Most Liquid of all Liquid Assets: Money is the most liquid of all liquid
technological process. This, in turn, increases the national product and improves the standard
assets in which wealth is held. Individuals and firms may hold wealth in infinitely varied forms.
of living of the people.
“They may, for example, choose between holding wealth in currency, demand deposits, time
deposits, savings, bonds, Treasury Bills, short-term government securities, long-term
(iv)Effect on Government Expenditure: The monetary system has also influenced the
government securities, debentures, preference shares, ordinary shares, stocks of consumer
expenditure of the modern governments. Through deficit financing, the present governments
goods, and productive equipment.” All these are liquid forms of wealth which can be converted
are able to spend much more than what they receive by way of taxation or other sources of
into money, and vice-versa.
revenue. This enables the government to undertake a number of economic, social and defence
activities in the country.
(ii) Basis of the Credit System: Money is the basis of the credit system. Business transactions
are either in cash or on credit. Credit economises the use of money. But money is at the back
ADVANTAGES OF MONEY:
of all credit. A commercial bank cannot create credit without having sufficient money in
reserve. The credit instruments drawn by businessmen have always cash guarantee supported
(i) Economical: Paper money practically costs nothing to the Government. Currency notes,
by their bankers.
therefore, are the cheapest media of exchange. If a country uses paper money, it need not spend
anything on the purchase of gold or minting coins. The loss which a country suffers from the
(iii) Equaliser of Marginal Utilities and Productivities: Money acts as an equaliser of
wear and tear of metallic money is also avoided.
marginal utilities for the consumer. The main aim of a consumer is to maximise his satisfaction
by spending a given sum of money on various goods which he wants to purchase. Since prices
(ii) Convenient: Paper money is the most convenient form of money. A large amount can be
of goods indicate their marginal utilities and are expressed in money, money helps in equalising
carried conveniently in the pocket without anybody knowing it. It is very risky to carry on
the marginal utilities of various goods. This happens when the ratios of the marginal utilities
one’s person Rs. 5,000 in cash, but not in notes. It possesses, in a very large measure, the
and prices of the various goods are equal. Similarly, money helps in equalising the marginal
quality of portability which a money material should have. In a very small bulk, it can contain
productivities of the various factors. The main aim of the producer is to maximise his profits.
a very large value. Think of a currency note of Rs. 10,000.
For this, he equalises the marginal productivity of each factor with its price. The price of each
factor is nothing but the money he receives for his work.
(iii) Homogeneous: One essential quality in money is that it must be exactly of the same type.
Even among the coins there are good and bad coins. But currency notes are all exactly similar.
(iv) Measurement of National Income: It was not possible to measure the national income
It is, therefore, a very suitable medium of exchange.
under the barter system. Money helps in measuring national income. This is done when the
various goods and services produced in a country are assessed in money terms.
(iv) Stability: The value of paper money can be kept stable by properly regulating its issue.
That is why there are many advocates of ‘managed’ paper currency.

45 47
(b) Secondary functions which include standard of deferred payments, store of value and
transfer of value; and
(c) Contingent functions which include distribution of national income, maximization of
satisfaction, basis of credit system, etc. These functions have been explained below:
1. Primary Functions:
The two primary functions of money are to act as a medium of exchange and as a unit of value.
(i) Money as a Medium of Exchange:
This is the primary function of money because it is out of this function that its other functions
developed. By serving as a medium of exchange, money removes the need for double
coincidence of wants and the inconveniences and difficulties associated with barter. The
introduction of money as a medium of exchange decomposes the single transaction of barter
into separate transactions of sale and purchase thereby eliminating the double coincidence of
wants. As a medium of exchange, money acts as an intermediary. It facilitates exchange.
(ii) Money as Unit of Value:
The second primary function of money is to act as a unit of value. Under barter one would have
to resort to some standard of measurement, such as a length of string or a piece of wood. Since
one would have to use a standard to measure the length or height of any object, it is only
sensible that one particular standard should be accepted as the standard. Money is the standard
for measuring value just as the yard or metre is the standard for measuring length.
The monetary unit measures and expresses the values of all goods and services. In fact, the
monetary unit expresses the value of each good or service in terms of price. Money is the
common denominator which determines the rate of exchange between goods and services
which are priced in terms of the monetary unit.
Money as a unit of value also facilitates accounting. “Assets of all kinds, liabilities of all kinds,
income of all kinds, and expenses of all kinds can be stated in terms of common monetary units
to be added or subtracted.” Further, money as a unit of account helps in calculations of
economic importance such as the estimation of the costs, and revenues of business firms, the
relative costs and profitability of various public enterprises and projects under a planned
economy, and the gross national product.
2. Secondary Functions:
Money performs three secondary functions: as a standard of deferred payments, as a store of
value, and as a transfer of value.
(i) Money as a Standard of Deferred Payments:
The third function of money is that it acts as a standard of deferred or postponed payments. All
debts are taken in money. It was easy under barter to take loans in goats or grains but difficult
to make repayments in such perishable articles in the future. Money has simplified both the
taking and repayment of loans because the unit of account is durable.
Money links the present values with those of the future. It simplifies credit transactions. It
makes possible contracts for the supply of goods in the future for an agreed payment of money.
It simplifies borrowing by consumers on hire-purchase and from house-building and
cooperative societies. Money facilitates borrowing by firms and businessmen from banks and
other non-bank financial institutions. The buying and selling of shares, debentures and
44
(v) Elasticity: Paper money is absolutely elastic. Its quantity can be increased or decreased at
the will of the currency authority. Thus paper money can better meet the requirements of trade
and industry.
(vi) Cheap Remittance: Money in the form of currency notes can be cheaply remitted from
one place to another in an insured cover.
(vii) Advantageous to Banks: Paper money is of very great advantage to the banks. They can
keep their cash reserves against liabilities in this form, for currency notes are full legal tender.
(viii) Fiscal advantages to the Government of the paper currency are undoubtedly very great,
especially in times of national emergencies like a war. A modern war cannot be prosecuted by
taxes or loans alone. All governments have to resort to the printing press. In recent years in
India there has been great inflation. We must remember that by this means our Government
has been able to spend hundreds of crores of rupees on various ambitious programmes of
development. Hence within limits the issue of paper money comes very handy to the
government at the time of dire need.
DISADVANTAGES OF MONEY
Money is not an unmixed blessing. Total dependence or misuse of money may lead to
undesirable and harmful results. In the words of Robertson, “Money, which is a source of so
many blessings to mankind, becomes also, unless we can control it, a source of peril and
confusion. The following are the various disadvantages of money:
1. Instability: A great disadvantage of money is that its value does not remain constant which
creates instability in the economy. Too much of money reduces its value and causes inflation
(i.e., rise in price level) and too little of money raises its value and results in deflation (i.e., fall
in price level). Inflation distorts the pattern of distribution in favour of the rich; thus, it makes
the rich richer and the poor poorer. Deflation, on the other hand, results in unemployment and
hardships to the working class.
2. Inequality of Income: Money, through its excessive use and inflationary effect, creates and
widens the inequalities in the distribution of income and wealth. This had divided the society
into 'haves' and 'have-nots' and has led to a class conflict between them.
3. Growth of Monopolies: The use of money leads to the concentration of wealth in a few
hands and this gives rise to monopolies. Growth of monopolies results in the exploitation of
the workers, brings misery and degradation to them.
4. Over-Capitalization: Easy borrowing and lending facilities, made possible through money,
may lead certain industries to use more capital than is required. This over-capitalization, in
turn, results in over-production and unemployment.
5. Misuse of Capital: Money, which is the basis of credit, leads to the creation of more and
more credit creation. Credit creation, if not matched by the increase in production, results in
inflationary rise in the prices.
6. Hoarding: In the materialistic world, people give undue importance to money and, instead
of utilising in productive activities, may start hoarding. This would adversely affect the growth
of income, output and employment of the economy.
48
(4) Barriers to Entry of Firms: As there is keen competition in an oligopolistic industry, there
are no barriers to entry into or exit from it. However, in the long run, there are some types of
barriers to entry which tend to restraint new firms from entering the industry.
(5) Lack of Uniformity: Another feature of oligopoly market is the lack of uniformity in the
size of firms. Finns differ considerably in size. Some may be small, others very large. Such a
situation is asymmetrical. This is very common in the American economy. A symmetrical
situation with firms of a uniform size is rare.
(7) No Unique Pattern of Pricing Behaviour: The rivalry arising from interdependence
among the oligopolists leads to two conflicting motives. Each wants to remain independent and
to get the maximum possible profit. Towards this end, they act and react on the price-output
movements of one another in a continuous element of uncertainty.
On the other hand, again motivated by profit maximisation each seller wishes to cooperate with
his rivals to reduce or eliminate the element of uncertainty. All rivals enter into a tacit or formal
agreement with regard to price-output changes. It leads to a sort of monopoly within oligopoly.
MONOPOLISTIC COMPETITION:
Monopolistic competition refers to a market situation where there are many firms selling a
differentiated product. “There is competition which is keen, though not perfect, among many
firms making very similar products.” No firm can have any perceptible influence on the price-
output policies of the other sellers nor can it be influenced much by their actions. Thus
monopolistic competition refers to competition among a large number of sellers producing
close but not perfect substitutes for each other.
Features
The following are the main features of monopolistic competition:
(1) Large Number of Sellers: In monopolistic competition the number of sellers is large. They
are “many and small enough” but none controls a major portion of the total output. No seller
by changing its price-output policy can have any perceptible effect on the sales of others and
in turn be influenced by them. Thus there is no recognised interdependence of the price-output
policies of the sellers and each seller pursues an independent course of action.
(2) Product Differentiation: One of the most important features of the monopolistic competi-
tion is differentiation. Product differentiation implies that products are different in some ways
from each other. They are heterogeneous rather than homogeneous so that each firm has an
absolute monopoly in the production and sale of a differentiated product.
(3) Freedom of Entry and Exit of Firms: Another feature of monopolistic competition is the
freedom of entry and exit of firms. As firms are of small size and are capable of producing
close substitutes, they can leave or enter the industry or group in the long run.
(4) Nature of Demand Curve: Under monopolistic competition no single firm controls more
than a small portion of the total output of a product. No doubt there is an element of
differentiation nevertheless the products are close substitutes. As a result, a reduction in its
price will increase the sales of the firm but it will have little effect on the price-output
conditions of other firms, each will lose only a few of its customers.
Likewise, an increase in its price will reduce its demand substantially but each of its rivals will
attract only a few of its customers. Therefore, the demand curve (average revenue curve) of a
firm under monopolistic competition slopes downward to the right. It is elastic but not perfectly
elastic within a relevant range of prices of which he can sell any amount.
42
(v) Distribution of National Income: Money also helps in the distribution of national income.
Rewards of factors of production in the form of wages, rent, interest and profit are determined
and paid in terms of money.
4. Other Functions:
Money also performs such functions which affect the decisions of consumers and governments.
(i) Helpful in making decisions: Money is a means of store of value and the consumer meets
his daily requirements on the basis of money held by him. If the consumer has a scooter and in
the near future he needs a car, he can buy a car by selling his scooter and money accumulated
by him. In this way, money helps in taking decisions.
(ii) Money as a Basis of Adjustment: To carry on trade in a proper manner, the adjustment
between money market and capital market is done through money. Similarly, adjustments in
foreign exchange are also made through money. Further, international payments of various
types are also adjusted and made through money. It is on the basis of these functions that money
guarantees the solvency of the payer and provides options to the holder of money to use it any
way, he likes.
STATIC AND DYNAMIC FUNCTIONS OF MONEY
Paul Einzing has classified the functions of money into two broad categories, i.e., static and
dynamic functions:
1. Static Functions:
Static functions of money are those which are related to the operation of economy and do not
generate any momentum or force. On this basis the functions of money like medium of
exchange, store of value, standard of deferred payments, transfer of value etc. can be termed
as primary and static functions for these functions do not generate any force or momentum.
Static functions of manes arc also known as passive functions, traditional functions, fixed
functions and technical functions for these functions have to be performed by money
mechanically in all conditions and in all economics, These functions are known as Static
Functions because their form and nature is the same at all places in all countries and in all types
of economies. The nature of these functions is traditional.
In the static functions, money acts as a passive or technical tool to ensure a smooth working of
the economic system. It does not have a causative influence on the economic activities. The
traditional functions of money, i.e., medium of exchange, measure of value, standard of
deferred payments and store of value, all are the static or technical functions of money.
Paul Einzing adds one more technical function, i.e., money as a medium of price mechanism.
Prices are the value of goods and services, expressed in money terms. Money is a medium
through which the price mechanism operates in order to establish a balance between demand
and supply in the market, and, thereby, to reconcile the interests of the producers and
consumers.
2. Dynamic Functions:
Dynamic functions are those which bring about changes in the economic conditions such as
price level, level of production and employment etc. Affecting liquidity of capital and
46

7. Black Money: Money, due to storability characteristic, is the cause of the evil of black
money. It provides people a convenient way to evade taxes by concealing their income. Black
money, in turn, encourages black marketing and speculative activities.
8. Political Instability: Wide fluctuations in prices and business activities, caused by money,
may lead to political instability. This may result in the change of government.
9. Moral and Social Evils: In the modern times, moral values have been sacrificed at the alter
of money. People have become so much money-minded that they openly indulge in corrupt
practices to satisfy their greed for money. Money is also the root cause of thefts, murders,
frauds and other social evils.
The defects of money do not, however, indicate its elimination. The advantages of money far
exceed its disadvantages. It is a good servant and a bad master. What is required is the proper
regulation of money supply through a wisely formulated monetary policy to ensure the efficient
working of the economic system and to achieve the socio-economic objectives of the economy.
MONEY SUPPLY
In economics, the money supply or money stock, is the total amount of monetary assets
available in an economy at a specific time. There are several ways to define "money," but
standard measures usually include currency in circulation and demand deposits (depositors'
easily accessed assets on the books of financial institutions).
Definition: The total stock of money circulating in an economy is the money supply. The
circulating money involves the currency, printed notes, money in the deposit accounts and in
the form of other liquid assets.
MEASURES OF MONEY SUPPLY
Different measures of money supply. Not all of them are widely used and the exact
classifications depend on the country. M0 and M1, also called narrow money, normally include
coins and notes in circulation and other money equivalents that are easily convertible into cash.
M2 includes M1 plus short-term time deposits in banks and 24-hour money market funds. M3
includes M2 plus longer-term time deposits and money market funds with more than 24-hour
maturity. The exact definitions of the three measures depend on the country. M4 includes M3
plus other deposits. The term broad money is used to describe M2, M3 or M4, depending on
the local practice.
Some of the important measures of money supply in India are as follows:
There are four measures of money supply in India which are denoted by M 1, M2, M3 and M4.
This classification was introduced by the Reserve Bank of India (RBI) in April 1977. Prior to
this till March 1968, the RBI published only one measure of the money supply, M or defined
as currency and demand deposits with the public. This was in keeping with the traditional and
Keynesian views of the narrow measure of the money supply.
From April 1968, the RBI also started publishing another measure of the money supply which
it called Aggregate Monetary Resources (AMR). This included M1 plus time deposits of banks
held by the public. This was a broad measure of money supply which was in line with
Friedman’s view. But since April 1977, the RBI has been publishing data on four measures of
the money supply which are discussed as under.
49
x Collections - a bank will act as your agent to collect funds from another bank payable
to you, such as when someone pays you by check drawn on an account from a different
bank
x Invest funds in securities for a return
x Safeguard money - banks are considered a safe place to store your wealth
x Maintain and service savings and checking accounts of its depositors
x Maintain custodial accounts - accounts controlled by one person but for the benefit of
another person, such as a trust account
™ Industrial Banks:
Industrial / Development banks collect cash by issuing shares & debentures and providing long-
term loans to industries. The main objective of these banks is to provide long-term loans for
expansion and modernisation of industries.
In India such banks are established on a large scale after independence. They are Industrial
Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India
(ICICI) and Industrial Development Bank of India (IDBI).
™ Agricultural Bank:
A type of bank that lends money to farmers for longerperiods of time and charges them less
interest than other types of banks.
National Bank for Agriculture and Rural Development (NABARD) is an apex development
bank in India having headquarters based in Mumbai (Maharashtra) and other branches are all
over the country. The Committee to Review Arrangements for Institutional Credit for
Agriculture and Rural Development (CRAFICARD), set up by the Reserve Bank of India
(RBI) under the Chairmanship of Shri B. Sivaraman, conceived and recommended the
establishment of the National Bank for Agriculture and Rural Development (NABARD). It was
established on 12 July 1982 by a special act by the parliament and its main focus was to uplift
rural India by increasing the credit flow for elevation of agriculture & rural non-farm sector
and completed its 25 years on 12 July 2007.
™ Exchange Banks
Hong Kong Bank, Bank of Tokyo, Bank of America are the examples of Foreign Banks
working in India. These banks are mainly concerned with financing foreign trade.
Following are the various functions of Exchange Banks:-
x Remitting money from one country to another country,
x Discounting of foreign bills,
x Buying and Selling Gold and Silver, and
x Helping Import and Export Trade.
Basically, an exchange bank allows customers to exchange one money currency for another
one. Often they are a standalone business but may be part of a larger institution.
™ Saving Banks
Saving banks are established to create saving habit among the people. These banks are helpful
for salaried people and low income groups. The deposits collected from customers are invested
53
DEFINITION OF 'BROAD MONEY'
In economics, broad money refers to the most inclusive definition of the money supply. Since
cash can be exchanged for many different financial instruments and placed in various restricted
accounts, it is not a simple task for economists to define how much money is currently in the
economy. Therefore, the money supply is measured in many different ways. Broad money is
used colloquially to refer to a broad definition of the money supply.
One measure of the money supply that includes M1, plus savings and small time deposits,
overnight repos at commercial banks, and non-institutional money market accounts. This is a
key economic indicator used to forecast inflation, since it is not as narrow as M1 and still
relatively easy to track. All the components of M2 are very liquid, and the non-cash
components can be converted into cash very easily.
BANKING: MEANING AND DEFINITION
Finance is the life blood of trade, commerce and industry. Now-a-days, banking sector acts as
the backbone of modern business. Development of any country mainly depends upon the
banking system. A bank is a financial institution which deals with deposits and advances and
other related services. It receives money from those who want to save in the form of deposits
and it lends money to those who need it. It deals with deposits and advances and other related
services like lending money to grow the economy. Banks act as bridge between the people who
save and people who want to borrow i.e., It receives money from those people who want to
save as deposits and it lends money to those who want to borrow it. The money you deposited
in bank will not be idle. It will grow by means of interest to your bank account they will earn
interest in return for lending out the same money to borrowers. This would ensure smooth
money flow to develop our economy.
According to Banking Regulation Act, “Banking means the accepting for the purpose of
lending or investment of deposits of money from the public, repayable on demand or otherwise
and withdrawable by cheque, draft, and an order or otherwise”.
DEFINITION OF A BANK
The term bank is either derived from Old Italian word banca or from a French
word banque both mean a Bench or money exchange table. In olden days, European money
lenders or money changers used to display (show) coins of different countries in big heaps
(quantity) on benches or tables for the purpose of lending or exchanging.
A bank is a financial institution which deals with deposits and advances and other related
services. It receives money from those who want to save in the form of deposits and it lends
money to those who need it.
Chamber’s Twentieth century Dictionary defines a bank as, “an institution for the
keeping, lending and exchanging etc. of money”.
Prof. Kent defines a bank as, “an organization whose principal operations are
concerned with the accumulation of the temporarily idle money of the general public for the
purpose of advancing to others for expenditure”.
51
x Co-operative bank:
The banks which are established and controlled under Co-operative Societies Act are
called co-operative banks. Co-operative banks are banks incorporated in the legal form of
cooperatives. Any cooperative society has to obtain a license from the Reserve Bank of India
before starting banking business and has to follow the guidelines set and issued by the Reserve
Bank of India.
Currently, there are 68 co-operatives banks in India. There are three types of co-operatives
banks with different functions:
1. Primary Credit Societies: Primary Credit Societies are formed at the village or town
level with borrower and Non-borrower members residing in one locality. The
operations of each society are restricted to a small area so that the members know each
other and are able to watch over the activities of all members to prevent frauds.
2. Central Co-operative Banks: Central co-operative banks operate at the district level
having some of the primary credit societies belonging to the same district as their
members. These banks provide loans to their members (i.e., primary credit societies)
and function as a link between the primary credit societies and state co-operative banks.
3. State Co-operative Banks: These are the highest level co-operative banks in all the
states of the country. They mobilize funds and help in its proper channelization among
various sectors. The money reaches the individual borrowers from the state co-
operative banks through the central cooperative banks and the primary credit societies.
™ Classification On The Basis Of Domicile
x Domestic bank: The banks which are registered and incorporated within the country
are called domestic banks. These banks provide financial assistance domestically.
x Foreign banks: The banks which have their origin and head offices in the foreign
country are called foreign banks. Foreign banks are the branches of the banks
incorporated abroad. Foreign banks are registered and have their headquarters in a
foreign country but operate their branches in India. Apart from financing of foreign
trade, these banks have performed all functions of commercial banks and they have an
advantage over Indian banks because of their vast resources and superior management.
The Standard Chartered Bank Ltd, National and Grindlays Bank Ltd, Al-Falah
Bank Ltd, Bank of America, Bank of Bahrain & Kuwait, Bank of Ceylon, Citibank,
Hongkong & Shanghai Banking Corporation. (HSBC), JP Morgan Chase Bank are
some examples of foreign banks.
™ Scheduled bank and Non Scheduled bank:
Under the Reserve Bank of India Act, 1939, banks were classified as scheduled banks and non-
scheduled banks.. The scheduled banks are those which are entered in the second schedule of
RBI Act, 1939. Scheduled banks are those banks which have a paid up capital and reserves of
aggregate value of not less than Rs 5 lakhs and which satisfy RBI. All Commercial Banks,
Regional Rural Banks, State Cooperative Banks are scheduled banks.
55
CHARACTERISTICS / FEATURES OF A BANK
1. Dealing in Money: Bank is a financial institution which deals with other people's money
i.e. money given by depositors.
2. Individual / Firm / Company: A bank may be a person, firm or a company. A banking
company means a company which is in the business of banking.
3. Acceptance of Deposit: A bank accepts money from the people in the form of deposits
which are usually repayable on demand or after the expiry of a fixed period. It gives safety to
the deposits of its customers. It also acts as a custodian of funds of its customers.
4. Giving Advances: A bank lends out money in the form of loans to those who require it for
different purposes.
5. Payment and Withdrawal: A bank provides easy payment and withdrawal facility to its
customers in the form of cheques and drafts, It also brings bank money in circulation. This
money is in the form of cheques, drafts, etc.
6. Agency and Utility Services: A bank provides various banking facilities to its customers.
They include general utility services and agency services.
7. Profit and Service Orientation: A bank is a profit seeking institution having service
oriented approach.
8. Ever increasing Functions: Banking is an evolutionary concept. There is continuous
expansion and diversification as regards the functions, services and activities of a bank.
9. Connecting Link: A bank acts as a connecting link between borrowers and lenders of
money. Banks collect money from those who have surplus money and give the same to those
who are in need of money.
10. Banking Business: A bank's main activity should be to do business of banking which
should not be subsidiary to any other business.
11. Name Identity: A bank should always add the word "bank" to its name to enable people
to know that it is a bank and that it is dealing in money.
TYPES OF BANKS
™ Commercial Banks:
A commercial bank is a financial institution that is authorized by law to receive money from
businesses and individuals and lend money to them. Commercial banks are open to the public
and serve individuals, institutions, and businesses. A commercial bank is almost certainly the
type of bank you think of when you think about a bank because it is the type of bank that most
people regularly use. Banks are regulated by federal and state laws depending on how they are
organized and the services they provide. Commercial banks are also monitored through the
Federal Reserve System. A commercial bank is authorized to serve the following functions:
x Receive deposits - take money in from individuals and businesses (called depositors)
x Disburse payments - make payments upon the direction of its depositors, such as
honouring a check
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On the other hand, non-schedule banks are those banks whose total paid up capital is less than
Rs 5 lakh and RBI has no specific control over these banks. These banks are not included in
the second schedule of RBI Act, 1934.
FUNCTIONS OF COMMERCIAL BANKS
Primary and Secondary Functions of Commercial Banks
™ Primary Function:
1. Accepting Deposits:
It is the most important function of commercial banks. They accept deposits in several forms
according to requirements of different sections of the society. The main kinds of deposits are:
(i) Current Account Deposits or Demand Deposits: These deposits refer to those deposits which
are repayable by the banks on demand. Such deposits are generally maintained by businessmen
with the intention of making transactions with such deposits. They can be drawn upon by a
cheque without any restriction. Banks do not pay any interest on these accounts. Rather, banks
impose service charges for running these accounts.
(ii) Fixed Deposits or Time Deposits: Fixed deposits refer to those deposits, in which the
amount is deposited with the bank for a fixed period of time. Such deposits do not enjoy
cheque-able facility. These deposits carry a high rate of interest.
(iii) Saving Deposits: These deposits combine features of both current account deposits and
fixed deposits. The depositors are given cheque facility to withdraw money from their account.
But, some restrictions are imposed on number and amount of withdrawals, in order to
discourage frequent use of saving deposits. They carry a rate of interest which is less than
interest rate on fixed deposits. It must be noted that Current Account deposits and saving
deposits are chequable deposits, whereas, fixed deposit is a non-chequable deposit.
2. Advancing of Loans:
The deposits received by banks are not allowed to remain idle. So, after keeping certain cash
reserves, the balance is given to needy borrowers and interest is charged from them, which is
the main source of income for these banks. Different types of loans and advances made by
Commercial banks are:
(i) Cash Credit: Cash credit refers to a loan given to the borrower against his current assets like
shares, stocks, bonds, etc. A credit limit is sanctioned and the amount is credited in his account.
The borrower may withdraw any amount within his credit limit and interest is charged on the
amount actually withdrawn.
(ii) Demand Loans: Demand loans refer to those loans which can be recalled on demand by the
bank at any time. The entire sum of demand loan is credited to the account and interest is
payable on the entire sum.
(iii) Short-term Loans: They are given as personal loans against some collateral security. The
money is credited to the account of borrower and the borrower can withdraw money from his
account and interest is payable on the entire sum of loan granted.
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M1. The first measure of money supply, M1 consists of:
(i) Currency with the public which includes notes and coins of all denominations in circulation
excluding cash on hand with banks:
(ii) Demand deposits with commercial and cooperative banks, excluding inter-bank deposits;
and
(iii) ‘Other deposits’ with RBI which include current deposits of foreign central banks,
financial institutions and quasi-financial institutions such as IDBI, IFCI, etc., other than of
banks, IMF, IBRD, etc. The RBI characterizes as narrow money.
M2. The second measure of money supply is M2 which consists of M1 plus post office
savings bank deposits. Since savings bank deposits of commercial and cooperative banks are
included in the money supply, it is essential to include post office savings bank deposits. The
majority of people in rural and urban India have preference for post office deposits from the
safety viewpoint than bank deposits.
M3. The third measure of money supply in India is M3, which consists of M1, plus time
deposits with commercial and cooperative banks, excluding interbank time deposits. The RBI
calls M3 as broad money.
M4. The fourth measure of money supply is M4 which consists of M3 plus total post office
deposits comprising time deposits and demand deposits as well. This is the broadest measure
of money supply.
Liquidity and Ranking
NAME TYPE LIQUIDITY
M1 Narrow money highest
M2 Narrow money less than M1
M3 Broad money less than M2
M4 Broad money lowest liquidity
DEFINITION OF 'NARROW MONEY'
Money in forms that can be used as a medium of exchange, generally notes, coins, and certain
balances held by banks.
A category of money supply that includes all physical money like coins and currency along
with demand deposits and other liquid assets held by the central bank. In the United States
narrow money is classified as M1 (M0 + demand accounts), while in the U.K. M0 is referenced
as narrow money.
Narrow money is a colloquial term for the total of a country's physical currency plus
demand deposits and other liquid assets held by the central bank. The economic term for narrow
money is M1.Narrow money is the most accessible money in an economy, which is why it is
restricted to paper currency, coins and demand deposits (money in checking
accounts, savings accounts and other highly liquid accounts).Narrow money is the
most liquid form of money.
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in bonds, securities, etc. At present most of the commercial banks carry the functions of savings
banks. Postal department also performs the functions of saving bank.
The principal aim of saving banks is to collect and pool together the scattered savings of the
community. Saving banks are usually departments of commercial banks. There may be
separate saving-banks in some countries of the world. In Pakistan, there is-no saving bank.
Commercial banks and post offices carry on saving banks functions. The saving banks invest
funds in the safest government securities.
™ Central Banks:
Central banks are bankers’ banks, and these banks trace their history from the Bank of England.
They guarantee stable monetary and financial policy from country to country and play an
important role in the economy of the country. Typical functions include implementing
monetary policy, managing foreign exchange and gold reserves, making decisions regarding
official interest rates, acting as banker to the government and other banks, and regulating and
supervising the banking industry.
These banks buy government debt, have a monopoly on the issuance of paper money, and often
act as a lender of last resort to commercial banks. The term bank nowadays refers to these
commercial banks. The Central bank of any country supervises controls and regulates the
activities of all the commercial banks of that country. It also acts as a government banker. It
controls and coordinates currency and credit policies of any country. The Reserve Bank of
India is the central bank of India.
™ Classification On The Basis Of Ownership
On the basis of ownership, banks can be classified as follows:
x Public sector bank:
The banks which are Owned and controlled by the government of a country are called public
sector banks. These are banks where majority stake is held by the Government of India or
Reserve Bank of India. Some Public sector banks are: Allahabad Bank, Andhra Bank, Bank of
Baroda, Canara Bank, Indian Bank, Punjab & Sind Bank, Punjab National Bank, UCO Bank,
Vijaya Bank, State bank and its associates etc.
x Private sector bank:
The banks which are owned and operated by the private sector are called private sector
banks. Private Banks are banks that the majority of share capital is held by private individuals.
In Private sector small scheduled commercial banks and newly established banks with a
network of 8,965 branches are operating. To encourage competitive efficiency, the setting up
of new private bank is now encouraged. Some private sector banks are: Catholic Syrian Bank,
Dhanalakshmi Bank, Federal Bank, South Indian Bank, ING Vysya Bank etc.
Examples on new generation private sector banks are: Centurion Bank, HDFC Bank, ICICI
Bank, IDBI Bank Ltd., IndusInd Bank, Kotak Mahindra Bank, UTI Bank, Yes Bank etc.
54
 ™ Secondary Functions:
1. Overdraft Facility:
It refers to a facility in which a customer is allowed to overdraw his current account upto an
agreed limit. This facility is generally given to respectable and reliable customers for a short
period. Customers have to pay interest to the bank on the amount overdrawn by them.
2. Discounting Bills of Exchange:
It refers to a facility in which holder of a bill of exchange can get the bill discounted with bank
before the maturity. After deducting the commission, bank pays the balance to the holder. On
maturity, bank gets its payment from the party which had accepted the bill.
™ Agency Functions:
Commercial banks also perform certain agency functions for their customers. For these
services, banks charge some commission from their clients. Some of the agency functions are:
(i) Transfer of Funds: Banks provide the facility of economical and easy remittance of funds
from place-to-place with the help of instruments like demand drafts, mail transfers, etc.
(ii) Collection and Payment of Various Items: Commercial banks collect cheques, bills,’
interest, dividends, subscriptions, rents and other periodical receipts on behalf of their
customers and also make payments of taxes, insurance premium, etc. on standing instructions
of their clients.
(iii) Purchase and Sale of Foreign Exchange: Some commercial banks are authorized by the
central bank to deal in foreign exchange. They buy and sell foreign exchange on behalf of their
customers and help in promoting international trade.
(iv) Purchase and Sale of Securities: Commercial banks buy and sell stocks and shares of
private companies as well as government securities on behalf of their customers.
(v) Income Tax Consultancy: They also give advice to their customers on matters relating to
income tax and even prepare their income tax returns.
(vi) Trustee and Executor: Commercial banks preserve the wills of their customers as trustees
and execute them after their death as executors.
(vii) Letters of Reference: They give information about the economic position of their
customers to traders and provide the similar information about other traders to their customers.
™ General Utility Functions:
Commercial banks render some general utility services like:
(i) Locker Facility: Commercial banks provide facility of safety vaults or lockers to keep
valuable articles of customers in safe custody.
(ii) Traveller’s Cheques: Commercial banks issue traveller’s cheques to their customers to
avoid risk of taking cash during their journey.
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INFLATION
Inflation is the rate at which the general level of prices for goods and services is rising and,
consequently, the purchasing power of currency is falling. Central banks attempt to limit
inflation, and avoid deflation, in order to keep the economy running smoothly.
As a result of inflation, the purchasing power of a unit of currency falls. For example, if the
inflation rate is 2%, then a pack of gum that costs $1 in a given year will cost $1.02 the next
year. As goods and services require more money to purchase, the implicit value of that money
falls.
In economics inflation means, a rise in general level of prices of goods and services in a
economy over a period of time. When the general price level rises, each unit of currency buys
fewer goods and services. Thus, inflation results in loss of value of money. Another popular
way of looking at inflation is "too much money chasing too few goods.
In case the price of say only one commodity rise sharply but prices of other commodities fall,
it will not be termed as inflation. Similarly, in case due to rumors if the price of a commodity
rises during the day itself, it will not be termed as inflation.
Inflation occurs due to an imbalance between demand and supply of money, changes in
production and distribution cost or increase in taxes on products. When economy experiences
inflation, i.e. when the price level of goods and services rises, the value of currency reduces.
This means now each unit of currency buys fewer goods and services.
It has its worst impact on consumers. High prices of day-to-day goods make it difficult for
consumers to afford even the basic commodities in life. This leaves them with no choice but to
ask for higher incomes. Hence the government tries to keep inflation under control.
Contrary to its negative effects, a moderate level of inflation characterizes a good economy.
An inflation rate of 2 or 3% is beneficial for an economy as it encourages people to buy more
and borrow more, because during times of lower inflation, the level of interest rate also remains
low. Hence the government as well as the central bank always strives to achieve a limited level
of inflation.
TYPES OF INFLATION:
2 broad categories are:
(a) DEMAND - PULL INFLATION: In this type of inflation prices increase results from
an excess of demand over supply for the economy as a whole. Demand inflation occurs when
supply cannot expand any more to meet demand; that is, when critical production factors are
being fully utilized, also called Demand inflation.
Main Causes of Demand-Pull Inflation
1. A depreciation of the exchange rate increases the price of imports and reduces the
foreign price of a country's exports. If consumers buy fewer imports, while exports
grow, AD in will rise – and there may be a multiplier effect on the level of demand and
output
2. Higher demand from a fiscal stimulus e.g. lower direct or indirect taxes or higher
government spending. If direct taxes are reduced, consumers have more disposable
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The main advantages of giving the monopoly right of note issue to the central bank are given
below:
(i) It brings uniformity in the monetary system of note issue and note circulation.
(ii) The central bank can exercise better control over the money supply in the country. It
increases public confidence in the monetary system of the country.
(iii) Monetary management of the paper currency becomes easier. Being the supreme bank of
the country, the central bank has full information about the monetary requirements of the
economy and, therefore, can change the quantity of currency accordingly.
(iv) It enables the central bank to exercise control over the creation of credit by the commercial
banks.
(v) The central bank also earns profit from the issue of paper currency.
(vi) Granting of monopoly right of note issue to the central bank avoids the political
interference in the matter of note issue.
2. Banker, Agent and Adviser to the Government:
The central bank functions as a banker, agent and financial adviser to the government,
(a) As a banker to government, the central bank performs the same functions for the
government as a commercial bank performs for its customers. It maintains the accounts of the
central as well as state government; it receives deposits from government; it makes short-term
advances to the government; it collects cheques and drafts deposited in the government
account; it provides foreign exchange resources to the government for repaying external debt
or purchasing foreign goods or making other payments,
(b) As an Agent to the government, the central bank collects taxes and other payments on behalf
of the government. It raises loans from the public and thus manages public debt. It also
represents the government in the international financial institutions and conferences,
(c) As a financial adviser to the lent, the central bank gives advice to the government on
economic, monetary, financial and fiscal matters such as deficit financing, devaluation, trade
policy, foreign exchange policy, etc.
3. Bankers' Bank:
The central bank acts as the bankers' bank in three capacities:
(a) Custodian of the cash preserves of the commercial banks;
(b) As the lender of the last resort; and
(c) As clearing agent. In this way, the central bank acts as a friend, philosopher and guide to
the commercial banks
As a custodian of the cash reserves of the commercial banks the central bank maintains the
cash reserves of the commercial banks. Every commercial bank has to keep a certain percentage
of its cash balances as deposits with the central banks. These cash reserves can be utilised by
the commercial banks in times of emergency.
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(ii) Inflation is a monetary phenomenon and it is generally caused by excessive money supply.
(iii) Inflation is essentially an economic phenomenon as it originates in the economic system
and is the result of action and interaction of economic forces.
(iv)Inflation is a dynamic process as observed over the long period.
(v) A cyclical movement of prices is not inflation.
(vi)Pure inflation starts after full employment.
(vii) Inflation may be demand-pull or cost-push.
(viii) Excess demand in relation to the supply of everything is the essence of inflation.
CAUSES OF INFLATION (Factoring affecting Demand and Supply)
Factors Affecting Demand: Both Keynesians and monetarists believe that inflation is caused
by increase in aggregate demand. They point toward the following factors which raise it:
1. Increase in Money Supply: Inflation is caused by an increase in the supply of money which
leads to increase in aggregate demand. The higher the growth rate of the nominal money
supply, the higher is the rate of inflation. Modern quantity theorists do not believe that true
inflation starts after the full employment level. This view is realistic because all advanced
countries are faced with high levels of unemployment and high rates of inflation.
2. Increase in Disposable Income: When the disposable income of the people increases, it
raises their demand for goods and services. Disposable income may increase with the rise in
national income or reduction in taxes or reduction in the saving of the people.
3. Increase in Public Expenditure: Government activities have been expanding much with
the result that government expenditure has also been increasing at a phenomenal rate, thereby
raising aggregate demand for goods and services. Governments of both developed and
developing countries are providing more facilities under public utilities and social services, and
also nationalizing industries and starting public enterprises with the result that they help in
increasing aggregate demand.
4. Increase in Consumer Spending: The demand for goods and services increases when
consumer expenditure increases. Consumers may spend more due to conspicuous consumption
or demonstration effect. They may also spend more when they are given credit facilities to buy
goods on hire-purchase and installment basis.
5. Cheap Monetary Policy: Cheap monetary policy or the policy of credit expansion also leads
to increase in the money supply which raises the demand for goods and services in the
economy. When credit expands, it raises the money income of the borrowers which, in turn,
raises aggregate demand relative to supply, thereby leading to inflation. This is also known as
credit-induced inflation.
6. Deficit Financing: In order to meet its mounting expenses, the government resorts to deficit
financing by borrowing from the public and even by printing more notes. This raises aggregate
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4. Lender of Last Resort:
As the supreme bank of the country and the bankers' bank, the central bank acts as the lender
of the last resort. In other words, in case the commercial banks are not able to meet their
financial requirements from other sources, they can, as a last resort, approach the central bank
for financial accommodation. The central bank provides financial accommodation to the
commercial banks by rediscounting their eligible securities and exchange bills.
5. Clearing Agent: As the custodian of the cash reserves of the commercial banks, the central
bank acts as the clearing house for these banks. Since all banks have their accounts with the
central bank, the central bank can easily settle the claims of various banks against each other
with least use of cash.
DIFFERENCE BETWEEN CENTRAL BANK AND COMMERCIAL BANK
There are certain basic differences between a central bank and a commercial bank. They are:
(i) The central bank is the apex monetary institution, which has been specially empowered to
exercise control over the banking system of the country. The commercial bank, on the contrary,
is a constituent unit of the banking system.
(ii) The central bank does not operate with a profit motive. The primary aim of the central bank
is to achieve the objectives of the economic policy of the government and maximise the public
welfare through monetary measures. The commercial banks, on the other hand, have profit
earning as their primary objective.
(iii) The central bank is generally a state-owned institution, while the commercial banks are
normally privately owned institutions.
(jv) The central bank does not deal directly with the Public. The commercial banks, on the
contrary, directly deal with the public.
(v) The central bank does not compete with the commercial banks. Rather it helps them by
acting as the lender of the last resort.
(vi) The central bank has the monopoly of note-issue, whereas the commercial banks do not
enjoy such right.
(vii) The central bank is the custodian of the foreign exchange reserves of the country. The
commercial banks are only the dealers in foreign exchange.
(viii) The central bank acts as the banker to the government, the commercial banks act as
bankers to the general public.
(ix) The central bank acts as the bankers' bank: (a) The commercial banks are required to keep
a certain proportion of their reserves with central bank; (b) the central bank helps them at the
time of emergency; and (c) the central bank acts as the clearing house for the commercial banks.
But, the Commercial banks perform no such function.
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demand in relation to aggregate supply, thereby leading to inflationary rise in prices. This is
also known as deficit-induced inflation.
7. Expansion of the Private Sector: The expansion of the private sector also tends to raise the
aggregate demand. For huge investments increase employment and income, thereby creating
more demand for goods and services. But it takes time for the output to enter the market. This
leads to rise in prices.
8. Black Money: The existence of black money in all countries due to corruption, tax evasion
etc. increases the aggregate demand. People spend such unearned money extravagantly,
thereby creating unnecessary demand for commodities. This tends to raise the price level
further.
9. Repayment of Public Debt: Whenever the government repays its past internal debt to the
public, it leads to increase in the money supply with the public. This tends to raise the aggregate
demand for goods and services and to rise in prices.
10. Increase in Exports: When the demand for domestically produced goods increases in
foreign countries, this raises the earnings of industries producing export commodities. These,
in turn, create more demand for goods and services within the economy, thereby leading to rise
in the price level.
Factors Affecting Supply:
There are also certain factors which operate on the opposite side and tend to reduce the
aggregate supply. Some of the factors are as follows:
1. Shortage of Factors of Production: One of the important causes affecting the supplies of
goods is the shortage of such factors as labour, raw materials, power supply, capital, etc. They
lead to excess capacity and reduction in industrial production, thereby raising prices.
2. Industrial Disputes: In countries where trade unions are powerful, they also help in
curtailing production. Trade unions resort to strikes and if they happen to be unreasonable from
the employers’ viewpoint and are prolonged, they force the employers to declare lock-outs.In
both cases, industrial production falls, thereby reducing supplies of goods. If the unions
succeed in rising money wages of their members to a very high level than the productivity of
labour, this also tends to reduce production and supplies of goods. Thus they tend to raise
prices.
3. Natural Calamities: Drought or floods is a factor which adversely affects the supplies of
agricultural products. The latter, in turn, create shortages of food products and raw materials,
thereby helping inflationary pressures.
4. Artificial Scarcities: Artificial scarcities are created by hoarders and speculators who
indulge in black marketing. Thus they are instrumental in reducing supplies of goods and
raising their prices.
5. Increase in Exports: When the country produces more goods for export than for domestic
consumption, this creates shortages of goods in the domestic market. This leads to inflation in
the economy.
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(iii) Letter of Credit: They also issue letters of credit to their customers to certify their
creditworthiness.
(iv)Underwriting Securities: Commercial banks also undertake the task of underwriting
securities. As public has full faith in the creditworthiness of banks, public do not hesitate in
buying the securities underwritten by banks.
(v) Collection of Statistics: Banks collect and publish statistics relating to trade, commerce
and industry. Hence, they advise customers on financial matters. Commercial banks receive
deposits from the public and use these deposits to give loans. However, loans offered are many
times more than the deposits received by banks. This function of banks is known as ‘Money
Creation’.
CENTRAL BANK – MEANING
A modern central bank performs so many functions of different nature that it is very difficult
to give any brief but accurate definition of a central bank. Any definition of a central bank is
derived from its functions and these functions have varied from time to time and from country
to country. In other words, the functions of central banks have grown over time making it more
difficult to give any brief and unchanging definition of a central bank. We may say that a central
bank is one which acts as the banker to the governments and the commercial banks, has the
monopoly of note issue, operates the currency and credit system of the country and does not
perform the ordinary commercial banking function.
Economists have defined central bank differently, emphasizing its one function or the
other. According to Vera Smith, “the primary definition of Central banking is a banking system
in which a single bank has either complete or a residuary monopoly of note issue”. In the
statutes of the Bank for International Settlements, a central bank is the bank in any country to
which has been entrusted the duty of regulating the volume of currency and credit in the
country”. The fact that several banks have been named bank reserves is the characteristic
function of a central bank.
A central bank, reserve bank, or monetary authority is an institution that manages a
state's currency, money supply, and interest rates. Central banks also usually oversee the
commercial banking system of their respective countries.
FUNCTIONS OF CENTRAL BANK
The central bank generally performs the following functions:
1. Bank of Note Issue:
The central bank has the sole monopoly of note issue in almost every country. The currency
notes printed and issued by the central bank become unlimited legal tender throughout the
country. In the words of De Kock, "The privilege of note-issue was almost everywhere
associated with the origin and development of central banks."
However, the monopoly of central bank to issue the currency notes may be partial in certain
countries. For example, in India, one rupee notes are issued by the Ministry of Finance and all
other notes are issued by the Reserve Bank of India.
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income causing demand to rise. Higher government spending and increased borrowing
creates extra demand in the circular flow
3. Monetary stimulus to the economy: A fall in interest rates may stimulate too much
demand – for example in raising demand for loans or in leading to house price inflation.
Monetarist economists believe that inflation is caused by “too much money chasing too
few goods" and that governments can lose control of inflation if they allow the financial
system to expand the money supply too quickly.
4. Fast growth in other countries – providing a boost to UK exports overseas. Export
sales provide an extra flow of income and spending into the UK circular flow – so what
is happening to the economic cycles of other countries definitely affects the UK
(b) COST - PUSH INFLATION: This type of inflation occurs when general price levels rise
owing to rising input costs. In general, there are three factors that could contribute to Cost-Push
inflation: rising wages increases in corporate taxes, and imported inflation. [Imported raw or
partly-finished goods may become expensive due to rise in international costs or as a result
of depreciation of local currency]
There are many reasons why costs might rise:
1. Component costs: e.g. an increase in the prices of raw materials and other components.
This might be because of a rise in commodity prices such as oil, copper and agricultural
products used in food processing. A recent example has been a surge in the world price
of wheat.
2. Rising labour costs - caused by wage increases, which are greater than improvements
in productivity. Wage costs often rise when unemployment is low because skilled
workers become scarce and this can drive pay levels higher. Wages might increase
when people expect higher inflation so they ask for more pay in order to protect their
real incomes. Trade unions may use their bargaining power to bid for and achieve
increasing wages, this could be a cause of cost-push inflation
3. Expectations of inflation are important in shaping what actually happens to inflation.
When people see prices are rising for everyday items they get concerned about the
effects of inflation on their real standard of living. One of the dangers of a pick-up in
inflation is what the Bank of England calls “second-round effects" i.e. an initial rise in
prices triggers a burst of higher pay claims as workers look to protect their way of life.
This is also known as a “wage-price effect"
4. Higher indirect taxes – for example a rise in the duty on alcohol, fuels and cigarettes,
or a rise in Value Added Tax. Depending on the price elasticity of demand and supply
for their products, suppliers may choose to pass on the burden of the tax onto
consumers.
5. A fall in the exchange rate – this can cause cost push inflation because it leads to an
increase in the prices of imported products such as essential raw materials, components
and finished products
6. Monopoly employers/profit-push inflation – where dominants firms in a market use
their market power (at whatever level of demand) to increase prices well above costs
FEATURES OF INFLATION
(i) Inflation is always accompanied by a rise in the price level. It is a process of uninterrupted
increase in prices.
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6. Lop-sided Production: If the stress is on the production of comfort, luxury, or basic
products to the neglect of essential consumer goods in the country, this creates shortages or
consumer goods. This again causes inflation.
7. Law of Diminishing Returns: If industries in the country are using old machines and
outmoded methods of production, the law of diminishing returns operates. This raises cost per
unit of production, thereby raising the prices of products.
8. International Factors: In modern times, inflation is a worldwide phenomenon. When prices
rise in major industrial countries, their effects spread to almost all countries with which they
have trade relations. Often the rise in the price of a basic raw material like petrol in the
international market leads to rise in the prices of all related commodities in a country.
CONTROLLING INFLATION: 3 IMPORTANT MEASURES TO CONTROL
INFLATION
Some of the important measures to control inflation are as follows:
1. Monetary Measures
2. Fiscal Measures
3. Other Measures.
Inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand.
Inflation can, therefore, be controlled by increasing the supplies of goods and services and
reducing money incomes in order to control aggregate demand.
The various methods are usually grouped under three heads: monetary measures, fiscal
measures and other measures.
1. MONETARY MEASURES:
Monetary measures aim at reducing money incomes.
(a) Credit Control: One of the important monetary measures is monetary policy. The central
bank of the country adopts a number of methods to control the quantity and quality of credit.
For this purpose, it raises the bank rates, sells securities in the open market, raises the reserve
ratio, and adopts a number of selective credit control measures, such as raising margin
requirements and regulating consumer credit. Monetary policy may not be effective in
controlling inflation, if inflation is due to cost-push factors. Monetary policy can only be
helpful in controlling inflation due to demand-pull factors.
(b) Demonetisation of Currency: However, one of the monetary measures is to demonetize
currency of higher denominations. Such a measures is usually adopted when there is abundance
of black money in the country.
(c) Issue of New Currency: The most extreme monetary measure is the issue of new currency
in place of the old currency. Under this system, one new note is exchanged for a number of
notes of the old currency. The value of bank deposits is also fixed accordingly. Such a measure
is adopted when there is an excessive issue of notes and there is hyperinflation in the country.
It is a very effective measure. But is inequitable for its hurts the small depositors the most.
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Given the supply of money, increase in liquidity preference results in the rise in the rate of
interest which also reduces investment.
To sum up, according to Keynes, rising rate of interest, declining MEC, falling tendency of
consumption all these factors lead to reduce aggregate demand which ultimately result in
deflationary conditions in the economy.
(2) Contractionary Monetary Policy: When the government adopts a contractionary
monetary policy, it makes the availability of credit more costly by raising the rate of interest
and reducing the supply of money. This results in fall in prices. Various contractionary
monetary measures are: raising the bank rate, sale of government securities, raising the cash
reserve ratio, reducing the currency, etc.
(3) Reduction in Government Expenditure: If the government decides to reduce public
expenditure, it will reduce national income and employment multiple times (through the
adverse working of multiplier). This will reduce aggregate demand, discourage investment and
affect the economic activity of the economy adversely.
(4) Heavy Taxes: Heavy taxes imposed by the government reduce the disposable income with
the people. This leads to the decline in both consumption and investment expenditure and
results in deflationary conditions.
(5) Increasing Economic Inequalities: Increasing inequalities of income and wealth make the
rich more rich and the poor more poor. Since the marginal propensity to consume (MPC) of
the rich is less than that of the poor, growing inequalities of income will reduce consumption
expenditure and will lead to deflationary situation.
(6) Public Borrowing: When the government borrows from the public, it results in the transfer
of money from the public to the government. This reduces aggregate demand and brings
deflation in the economy.
(7) Psychological Factors: Some economists feel that deflation and depression are the result
of waves of optimism and pessimism. During the optimistic conditions of boom, they make
over- investment. As a consequence, they fail to find buyers for their products, suffer losses,
grow pessimistic about the prospects of business and curtail their productive activities. Thus,
the discovery of error of optimism gives birth to the opposite error of pessimism.
(8) Other Factors: Some other non-economic and non-monetary factors, such as, wars, earth
quakes, strikes, crop failures, etc.
CONSEQUENCES OF DEFLATION
Consistent fall in the general price level in the economy (deflation) might not be good news for
the economy. Long term deflation will lead to:
™ Cyclical unemployment: Deflation usually happens to due to a fall in Aggregate
Demand in the economy. This will lead to businesses cutting the output levels which
will result in retrenchment/laying off of workers. Moreover, if consumers delay
spending in anticipation of falling prices economic activity falls, unemployment
increases.
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(i) One of the foremost measures to control inflation is to increase the production of essential
consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.
(ii) If there is need, raw materials for such products may be imported on preferential basis to
increase the production of essential commodities,
(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace
should be maintained through agreements with trade unions, binding them not to resort to
strikes for some time,
(iv)The policy of rationalisation of industries should be adopted as a long-term measure.
Rationalisation increases productivity and production of industries through the use of brain,
brawn and bullion,
(v) All possible help in the form of latest technology, raw materials, financial help, subsidies,
etc. should be provided to different consumer goods sectors to increase production.
(b) Rational Wage Policy: Another important measure is to adopt a rational wage and income
policy. Under hyperinflation, there is a wage-price spiral. To control this, the government
should freeze wages, incomes, profits, dividends, bonus, etc.
But such a drastic measure can only be adopted for a short period as it is likely to antagonise
both workers and industrialists. Therefore, the best course is to link increase in wages to
increase in productivity. This will have a dual effect. It will control wages and at the same time
increase productivity, and hence raise production of goods in the economy.
(c) Price Control: Price control and rationing is another measure of direct control to check
inflation. Price control means fixing an upper limit for the prices of essential consumer goods.
They are the maximum prices fixed by law and anybody charging more than these prices is
punished by law. But it is difficult to administer price control.
(d) Rationing: Rationing aims at distributing consumption of scarce goods so as to make them
available to a large number of consumers. It is applied to essential consumer goods such as
wheat, rice, sugar, kerosene oil, etc. It is meant to stabilise the prices of necessaries and assure
distributive justice. But it is very inconvenient for consumers because it leads to queues,
artificial shortages, corruption and black marketing. Keynes did not favour rationing for it
“involves a great deal of waste, both of resources and of employment.”
DEFLATION
Definition: When the overall price level decreases so that inflation rate becomes negative, it
is called deflation. It is the opposite of the often-encountered inflation.
Description: A reduction in money supply or credit availability is the reason for deflation in
most cases. Reduced investment spending by government or individuals may also lead to this
situation. Deflation leads to a problem of increased unemployment due to slack in demand.
Central banks aim to keep the overall price level stable by avoiding situations of severe
deflation/inflation. They may infuse a higher money supply into the economy to counter-
balance the deflationary impact. In most cases, a depression occurs when the supply of goods
is more than that of money.
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money. The government should adopt a budgetary deficit (excess of government expenditure
over its revenue) and cover this deficit through deficit financing. Deficit financing makes
available to the government sufficient resources for its developmental programmes without
adversely affecting investment in the private sector.
7. Reduction in Interest Rate: By adopting a cheap money policy, the monetary authority of
a country reduced the interest rate, which stimulates investment and thereby expands economic
activity in the economy.
8. Credit Expansion: The central bank and the commercial banks should adopt a policy of
credit expansion to promote business and industry in the country. Bank credit should be made
easily available to the entrepreneurs for productive purposes.
9. Foreign Trade Policy: To control deflation, the government should adopt such a foreign
trade policy that, on the one hand, increases exports, and, on the other hand, reduces imports.
This kind of policy will go a long way in solving the problem of overproduction, and help
overcoming deflation.
10. Regulation of Production: Production in the economy should be regulated in such a way
that the problem of over-production does not arise. Attempts should be made to adjust
production with the existing demand to avoid over-production.
In short, fiscal policy alone or monetary policy alone is not sufficient to check deflation in an
economy. A proper co- ordination of fiscal, monetary and other measures is essential to
effectively deal with the deflationary situation.
MONETARY POLICY
Monetary policy is the process by which monetary authority of a country, generally a central
bank controls the supply of money in the economy by its control over interest rates in order to
maintain price stability and achieve high economic growth.
Monetary policy refers to the credit control measures adopted by the central bank of a country.
Johnson defines monetary policy “as policy employing central bank’s control of the supply of
money as an instrument for achieving the objectives of general economic policy.” G.K. Shaw
defines it as “any conscious action undertaken by the monetary authorities to change the
quantity, availability or cost of money.”
OBJECTIVES OR GOALS OF MONETARY POLICY:
1. Full Employment: Full employment has been ranked among the foremost objectives of
monetary policy. It is an important goal not only because unemployment leads to wastage of
potential output, but also because of the loss of social standing and self-respect.
2. Price Stability:
One of the policy objectives of monetary policy is to stabilize the price level. Both economists
and laymen favour this policy because fluctuations in prices bring uncertainty and instability
to the economy.
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Deflation is different from disinflation as the latter implies decrease in the level of inflation
whereas on the other hand deflation implies negative inflation.
A decline in general price levels, often caused by a reduction in the supply of money or credit.
Deflation can also be brought about by direct contractions in spending, either in the form of a
reduction in government spending, personal spending or investment spending. Deflation has
often had the side effect of increasing unemployment in an economy, since the process
often leads to a lower level of demand in the economy.
IMPORTANT CAUSES OF DEFLATION
Deflation is a situation in which falling prices are accompanied by falling levels of
employment, income and output. Deflation may be due to certain natural causes, or it may be
due to a deliberate policy of the government. The following are the important causes of
deflation.
(1) Keynes' Explanation:
Keynes had developed a systematic theory to explain the causes of deflation (or depression).
(i) Deficient Aggregate Demand: The main reason for deflation is the deficiency of aggregate
demand which leads to over-production and unemployment. Aggregate demand consists of
aggregate consumption expenditure and aggregate investment expenditure.
(ii) Less Investment Expenditure: Private investment is governed by marginal efficiency of
capital (MEC) and rate of interest. Deflation is the result of decline in investment which is due
to (a) low MEC or low profitability of capital and (b) high rate of interest.
(iii) Fall in MEC: As the process of economic expansion goes on, certain forces come into
operation which exerts downward pressures on MEC. These forces are:
(a) During the process of expansion costs of production start rising on account of the increasing
scarcities of materials and equipment. Wage cost also rises because of scarcity of labour. Rising
costs have the depressing effect on MEC.
(b) Increasing abundance of output resulting from industrial expansion leads to lessen the
returns below expectations which also depress MEC.
(iv) Less Consumption: The basic cause of deflation or depression lies in Keynes' concept of
consumption function or his\psychological law of consumption. According to this law, the
consumers do not spend the whole of the increment of their incomes on consumer goods. As
the income increases, the community spends a smaller proportion of its increased income on
consumer goods. The reduced sale of consumer goods leads to the accumulation of stock of
consumer goods (or overproduction). This also has adverse effect on business expectations and
MEC.
(v) Rise in Rate of Interest: The fall in the MEC is followed by a rise in demand for money
or rise in liquidity preference (i.e., the tendency of the people to keep money in cash form). No
one likes to purchase goods or securities when the prices are falling.
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3. Economic Growth: One of the most important objectives of monetary policy in recent years
has been the rapid economic growth of an economy. Economic growth is defined as “the
process whereby the real per capita income of a country increases over a long period of time.”
4. Balance of Payments: Another objective of monetary policy since the 1950s has been to
maintain equilibrium in the balance of payments.
INSTRUMENTS OF MONETARY POLICY:
The instruments of monetary policy are of two types: first, quantitative, general or indirect; and
second, qualitative, selective or direct. They affect the level of aggregate demand through the
supply of money, cost of money and availability of credit.
Of the two types of instruments, the first category includes bank rate variations, open market
operations and changing reserve requirements. They are meant to regulate the overall level of
credit in the economy through commercial banks.
The selective credit controls aim at controlling specific types of credit. They include changing
margin requirements and regulation of consumer credit.
Bank Rate Policy: The bank rate is the minimum lending rate of the central bank at which it
rediscounts first class bills of exchange and government securities held by the commercial
banks. When the central bank finds that inflationary pressures have started emerging within the
economy, it raises the bank rate. Borrowing from the central bank becomes costly and
commercial banks borrow less from it.
The commercial banks, in turn, raise their lending rates to the business community and
borrowers borrow less from the commercial banks. There is contraction of credit and prices are
checked from rising further. On the contrary, when prices are depressed, the central bank
lowers the bank rate. It is cheap to borrow from the central bank on the part of commercial
banks. The latter also lower their lending rates. Businessmen are encouraged to borrow more.
Investment is encouraged. Output, employment, income and demand start rising and the
downward movement of prices is checked.
Open Market Operations: Open market operations refer to sale and purchase of securities in
the money market by the central bank. When prices are rising and there is need to control them,
the central bank sells securities. The reserves of commercial banks are reduced and they are
not in a position to lend more to the business community.
Further investment is discouraged and the rise in prices is checked. Contrariwise, when
recessionary forces start in the economy, the central bank buys securities. The reserves of
commercial banks are raised. They lend more. Investment, output, employment, income and
demand rise and fall in price is checked.
Changes in Reserve Ratios: This weapon was suggested by Keynes in his Treatise on Money
and the USA was the first to adopt it as a monetary device. Every bank is required by law to
keep a certain percentage of its total deposits in the form of a reserve fund in its vaults and also
a certain percentage with the central bank.
When prices are rising, the central bank raises the reserve ratio. Banks are required to keep
more with the central bank. Their reserves are reduced and they lend less. The volume of
investment, output and employment are adversely affected. In the opposite case, when the
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2. FISCAL MEASURES:
Monetary policy alone is incapable of controlling inflation. It should, therefore, be
supplemented by fiscal measures. Fiscal measures are highly effective for controlling
government expenditure, personal consumption expenditure, and private and public
investment. The principal fiscal measures are the following:
(a) Reduction in Unnecessary Expenditure: The government should reduce unnecessary
expenditure on non-development activities in order to curb inflation. This will also put a check
on private expenditure which is dependent upon government demand for goods and services.
But it is not easy to cut government expenditure. Though this measure is always welcome but
it becomes difficult to distinguish between essential and non-essential expenditure. Therefore,
this measure should be supplemented by taxation.
(b) Increase in Taxes: To cut personal consumption expenditure, the rates of personal,
corporate and commodity taxes should be raised and even new taxes should be levied, but the
rates of taxes should not be so high as to discourage saving, investment and production. Rather,
the tax system should provide larger incentives to those who save, invest and produce more.
Further, to bring more revenue into the tax-net, the government should penalize the tax evaders
by imposing heavy fines. Such measures are bound to be effective in controlling inflation. To
increase the supply of goods within the country, the government should reduce import duties
and increase export duties.
(c) Increase in Savings: Another measure is to increase savings on the part of the people. This
will tend to reduce disposable income with the people, and hence personal consumption
expenditure. But due to the rising cost of living, people are not in a position to save much
voluntarily.
Keynes, therefore, advocated compulsory savings or what he called ‘deferred payment’ where
the saver gets his money back after some years. For this purpose, the government should float
public loans carrying high rates of interest, start saving schemes with prize money, or lottery
for long periods, etc. It should also introduce compulsory provident fund, provident fund-cum-
pension schemes, etc. All such measures increase savings and are likely to be effective in
controlling inflation.
(d) Surplus Budgets: An important measure is to adopt anti-inflationary budgetary policy. For
this purpose, the government should give up deficit financing and instead have surplus budgets.
It means collecting more in revenues and spending less.
(e) Public Debt: At the same time, it should stop repayment of public debt and postpone it to
some future date till inflationary pressures are controlled within the economy. Instead, the
government should borrow more to reduce money supply with the public.
Like monetary measures, fiscal measures alone cannot help in controlling inflation. They
should be supplemented by monetary, non-monetary and non-fiscal measures.
3. OTHER MEASURES:
The other types of measures are those which aim at increasing aggregate supply and reducing
aggregate demand directly.
(a) To Increase Production:
The following measures should be adopted to increase production:
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™ Bankruptcies: As the value of money is increasing, it becomes difficult for debtors to
repay the load. Moreover, during deflation firms will be having lower profits due to
falling prices and will find it difficult to meet their liabilities. This might lead to greater
number of bankruptcies. Businesses see profits fall; as they do so dividends and
investment returns fall and so share prices fall.
™ Deflationary spiral: Consistent fall in prices may trigger deflationary spiral. As firms
make less profit, this leads to less profits, they might not be willing or able to invest
which will have negative implications on the economic growth. Moreover, as firms cut
cost by lay off workers, there is less income for the households and the aggregate
demand might fall. Due to a fall in consumer and business confidence the economy
might fall into a deflationary spiral.
The principle problem of deflation is that it leads to a rise in the real value of debt. In
the early stages low interest rates and low prices encourage borrowing but as the real weight
of the borrowing is recognised so borrowing is reduced.
MEASURES TO CONTROL DEFLATION
To fight deflation, attempts must be made to raise the volume of aggregate effective demand.
It will output, income and employment in the economy, Effective demand can be increased
partly by consumption expenditure and partly by increasing investment expenditure. Various
measures to increase consumption and investment expenditures in the economy.
1. Reduction in Taxation: The government should reduce the number and burden of various
taxes levied on commodities. This will increase the purchasing power of the people. As a result,
the demand for goods and services will increase. Moreover, sufficient tax relief should be given
to businessmen to encourage investment.
2. Redistribution of Income: Marginal propensity to consume can be raised by a redistribution
of income and wealth from the rich to the poor. Since the marginal propensity to consume of
the poor is high and that of the rich is low, such a measure will help increasing the aggregate
demand in the economy.
3. Repayment of Public Debt: During deflation period, the government can repay the old
public debts. This will increase the purchasing power of the people and push up effective
demand.
4. Subsidies: The government should give subsidies to induce the businessmen to increase
investment.
5. Public Works Programme: The government should also directly undertake public works
programme and thus increase expenditure in public sector. Care should, however, be taken that
the public works policy of the government does not adversely affect investment in the private
sector; it should supplement, and not supplant, private investment. For this, it is important that
only those projects should be selected for the government's public works policy, which is either
too big or not so profitable to attract private investment.
6. Deficit Financing: In order to have significant expansionary effects, the government's public
works schemes should be financed by the method of deficit financing, i.e, by printing new
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reserve ratio is lowered, the reserves of commercial banks are raised. They lend more and the
economic activity is favourably affected.
Selective Credit Controls:
Selective credit controls are used to influence specific types of credit for particular purposes.
They usually take the form of changing margin requirements to control speculative activities
within the economy. When there is brisk speculative activity in the economy or in particular
sectors in certain commodities and prices start rising, the central bank raises the margin
requirement on them. The result is that the borrowers are given less money in loans against
specified securities. For instance, raising the margin requirement to 60% means that the pledger
of securities of the value of Rs 10,000 will be given 40% of their value, i.e. Rs 4,000 as loan.
In case of recession in a particular sector, the central bank encourages borrowing by lowering
margin requirements.
For an effective anti-cyclical monetary policy, bank rate, open market operations, reserve ratio
and selective control measures are required to be adopted simultaneously. But it has been
accepted by all monetary theorists that (i) the success of monetary policy is nil in a depression
when business confidence is at its lowest ebb; and (ii) it is successful against inflation. The
monetarists contend that as against fiscal policy, monetary policy possesses greater flexibility
and it can be implemented rapidly.
LIMITATIONS OF MONETARY POLICY
1. Restricted Scope of Monetary Policy in Economic Development:
In reality the monetary policy has been assigned only a minor role in the process of economic
development. The monetary policy is not given any predominant role in the process of
economic development. The role assigned to the Reserve Bank is minor indeed. The Reserve
Bank in expected to see that the process of economic development should not be hindered for
want of availability of adequate funds.
2. Limited Role in Controlling Prices:
The monetary policy of Reserve bank has played only a limited role in controlling the
inflationary pressure. It has not succeeded in achieving the objective of growth with
stability.The role of monetary policy in combating inflation is strictly limited and that monetary
policy can be effective only if it is a part of an overall framework of policy which includes not
only fiscal and foreign exchange policy but also what is described as an income policy’. In
India, however, the monetary policy of the Reserve Bank is not appropriately integrated with
fiscal, foreign exchange and income policies.
3. Unfavourable Banking Habits:
An important limitation of the monetary policy is unfavourable banking habits of Indian
masses. People in India prefer to make use of cash rather than cheque. This means that a major
portion of the cash generally continues to circulate in the economy without returning to the
banks in the form of deposits. This reduces the credit creation capacity of the banks.
4. Underdeveloped Money Market:
Another limitation of monetary policy in India is underdeveloped money market. The weak
money market limits the coverage, as also the efficient working of the monetary policy. The
money market comprises of the parts, the organised money market and unorganised money
73
receipts and expenditure of central government." In other words, fiscal policy refers to the
policy of the government with regard to taxation, public expenditure and public borrowings.
The importance of fiscal policy is high in underdeveloped countries. The state has to play active
and important role. In a democratic society direct methods are not approved. So, the
government has to depend on indirect methods of regulations. In this way, fiscal policy is a
powerful weapon in the hands of government by means of which it can achieve the objectives
of development.
OBJECTIVES
The fiscal policy is designed to achieve certain objectives as follows:-
1. Development by effective Mobilisation of Resources
The principal objective of fiscal policy is to ensure rapid economic growth and development.
This objective of economic growth and development can be achieved by Mobilization of
Financial Resources. The central and the state governments in India have used fiscal policy to
mobilize resources.
The financial resources can be mobilized by:-
Taxation: Through effective fiscal policies, the government aims to mobilise resources by way
of direct taxes as well as indirect taxes because most important source of resource mobilisation
in India is taxation.
Public Savings: The resources can be mobilised through public savings by reducing
government expenditure and increasing surpluses of public sector enterprises.
Private Savings: Through effective fiscal measures such as tax benefits, the government can
raise resources from private sector and households. Resources can be mobilised through
government borrowings by ways of treasury bills, issue of government bonds, etc., loans from
domestic and foreign parties and by deficit financing.
2. Efficient allocation of Financial Resources: The central and state governments have tried
to make efficient allocation of financial resources. These resources are allocated for
Development Activities which includes expenditure on railways, infrastructure, etc. While
Non-development Activities includes expenditure on defence, interest payments, subsidies, etc.
But generally the fiscal policy should ensure that the resources are allocated for generation of
goods and services which are socially desirable. Therefore, India's fiscal policy is designed in
such a manner so as to encourage production of desirable goods and discourage those goods
which are socially undesirable.
3. Reduction in inequalities of Income and Wealth: Fiscal policy aims at achieving equity
or social justice by reducing income inequalities among different sections of the society. The
direct taxes such as income tax are charged more on the rich people as compared to lower
income groups. Indirect taxes are also more in the case of semi-luxury and luxury items, which
are mostly consumed by the upper middle class and the upper class. The government invests a
significant proportion of its tax revenue in the implementation of Poverty Alleviation
Programmes to improve the conditions of poor people in society.
4. Price Stability and Control of Inflation: One of the main objective of fiscal policy is to
control inflation and stabilize price. Therefore, the government always aims to control the
inflation by reducing fiscal deficits, introducing tax savings schemes, Productive use of
financial resources, etc.
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2. Forecasting: Another most serious limitation of fiscal policy is the practical difficulty of
observing the coming events of economic instability. Unless they are correctly observed the
amount of revenue to be raised, the amount of expenditure to be incurred or the nature and
extent of budget balance to be framed cannot be suitably planned. In fact, success of fiscal
measures depends on the accurate predictions of various economic activities. In its absence, it
proves to be a little bit erratic.

3. Correct Size and Nature of Fiscal Policy: The most important necessity on which the
success of fiscal policy will depend is the ability of public authority to frame the correct size
and nature of fiscal policy on the one hand and to foresee the correct timing of its application
on the other. It is, however, too much to expect that the government would be able to correctly
determine the size, nature of composition and appropriate execution-time of fiscal policy.

4. Fiscal Selectivity: When monetary policy is general in nature and impersonal in impact, the
fiscal policy, in contrast, is selective. The former permits the market mechanism to operate
smoothly. The latter, on the contrary, encroaches directly upon the market mechanism and
gives rise to an allocation of resources which may be construed as good or bad depending upon
one’s value judgements. A particular set of fiscal measures may have an excessively harsh
impact upon certain sectors, while leaving others almost unaffected.

5. Inadequacy of Fiscal Measures: In anti-depression fiscal policy, the expansion of public

spending and reduction on taxes are always important elements. The question arises naturally,
whether a specific variation in public spending or taxes will bear the desired results or not. In
case the injections or withdrawals from the circular flow are more or less than what are
required, the system will fail to move in the desired direction. This results in exaggeration of
instability in the economy.

6. Adverse Effect on Redistribution of Income: It is felt that fiscal policy measures

redistribute income, the actual effect will be uncertain. If income is redistributed in favour of
the low-income classes whose marginal propensity to consume is high, the effect will be
increase in total demand. But the fiscal action will be contractionary if larger part of the
additional income goes to people having higher marginal propensity to save.

7. Adverse Effect on debt Management: The use of fiscal instruments during unemployment
and depression is often associated with the subsequent problem of debt management. Because
deficit budgeting is the normal fiscal cure, public debt is made for financing it. And if the
process of recovery from depression is long, the creation of budget deficit year after year will
create a huge problem of debt repayment and debt management.

8. Adverse Psychological Reaction: Large deficit programmes financed by borrowings bring

about adverse psychological reactions. Rumours of government bankruptcy discourage
investors and often flight of capital takes place.

9. Hardships in U.D.Cs: The creation of additional income through compensatory fiscal

measures is not easily possible in underdeveloped countries as in advanced economies. This is
mainly because a stagnating agricultural sector dominates the largest part of their economy
where marginal propensity to consume is so high that most of the additional income is
consumed and the marketable surplus is the least.

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5. Employment Generation: The government is making every possible effort to increase
employment in the country through effective fiscal measure. Investment in infrastructure has
resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial
(SSI) units encourage more investment and consequently generates more employment. Various
rural employment programmes have been undertaken by the Government of India to solve
problems in rural areas. Similarly, self-employment scheme is taken to provide employment to
technically qualified persons in the urban areas.
6. Balanced Regional Development: Another main objective of the fiscal policy is to bring
about a balanced regional development. There are various incentives from the government for
setting up projects in backward areas such as Cash subsidy, Concession in taxes and duties in
the form of tax holidays, Finance at concessional interest rates, etc.
7. Reducing the Deficit in the Balance of Payment: Fiscal policy attempts to encourage more
exports by way of fiscal measures like Exemption of income tax on export earnings, Exemption
of central excise duties and customs, Exemption of sales tax and octroi, etc.
The foreign exchange is also conserved by providing fiscal benefits to import substitute
industries, imposing customs duties on imports, etc. The foreign exchange earned by way of
exports and saved by way of import substitutes helps to solve balance of payments problem. In
this way adverse balance of payment can be corrected either by imposing duties on imports or
by giving subsidies to export.
8. Capital Formation: The objective of fiscal policy in India is also to increase the rate of
capital formation so as to accelerate the rate of economic growth. An underdeveloped country
is trapped in vicious (danger) circle of poverty mainly on account of capital deficiency. In order
to increase the rate of capital formation, the fiscal policy must be efficiently designed to
encourage savings and discourage and reduce spending.
9. Increasing National Income: The fiscal policy aims to increase the national income of a
country. This is because fiscal policy facilitates the capital formation. This results in economic
growth, which in turn increases the GDP, per capita income and national income of the country.
10. Development of Infrastructure: Government has placed emphasis on the infrastructure
development for the purpose of achieving economic growth. The fiscal policy measure such as
taxation generates revenue to the government. A part of the government's revenue is invested
in the infrastructure development. Due to this, all sectors of the economy get a boost.
11. Foreign Exchange Earnings: Fiscal policy attempts to encourage more exports by way of
Fiscal Measures like, exemption of income tax on export earnings, exemption of sales tax and
octroi, etc. Foreign exchange provides fiscal benefits to import substitute industries. The
foreign exchange earned by way of exports and saved by way of import substitutes helps to
solve balance of payments problem.
LIMITATIONS OF FISCAL POLICY
1. Policy Lags: During the recent times, there is not much argument about the desirability or
otherwise of a discretionary fiscal policy. The burning question in this context is related with
the timing of the fiscal measures. Unless the variations in taxes and public expenditure are
neatly timed, the desired counter-cyclical effects cannot be realized. There is generally some
interval between the time when a particular action is needed and the time when a fiscal measure
has its impact felt. The duration of this interval determines the extent to which a specific fiscal
measure can be effective. This time interval comprises of three types of lags-recognition lag,
administrative lag and operational lag.
market. The money policy works only in organised money market. It fails to achieve the desired
results in unorganised money market.
5. Existence of Black Money:
The existence of black money in the economy limits the working of the monetary policy. The
black money is not recorded since the borrowers and lenders keep their transactions secret.
Consequently the supply and demand of money also not remain as desired by the monetary
policy.
6. Conflicting Objectives:
An important limitation of monetary policy arises from its conflicting objectives. To achieve
the objective of economic development the monetary policy is to be expansionary but contrary
to it to achieve the objective of price stability a curb on inflation can be realized by contracting
the money supply. The monetary policy generally fails to achieve a proper coordination
between these two objectives.
7. Influence of Non-Monetary Factors:
An important limitation of monetary policy is its ignorance of non-monetary factors. The
monetary policy can never be the primary factor in controlling inflation originating in real
factors, deficit financing and foreign exchange resources. The Reserve Bank has no control
over deficit financing. It cannot regulate the deficit financing, which affects money supply
considerably.
8. Limitations of Monetary Instruments:
An important limitation of monetary policy is related to the inherent limitations in the various
instruments of credit control. There are limitations regarding frequent and sharp changes in the
bank rate, as these are supposed to conflict with the development objectives. Most bank rates
are virtually fixed and mutually unrelated so that the scope for adjustment is very limited.
9. Not Proper Implementation of the Monetary Policy:
Successful application of monetary policy is not merely a question of availability of
instruments of credit control. It is also a question of judgement with regard to timing and the
degree of restraint employed or relaxation allowed.
FISCAL POLICY
Fiscal policy is the means by which a government adjusts its spending levels and tax rates to
monitor and influence a nation's economy. It is the sister strategy to monetary policy through
which a central bank influences a nation's money supply.
MEANING OF FISCAL POLICY
The fiscal policy is concerned with the raising of government revenue and incurring of
government expenditure. To generate revenue and to incur expenditure, the government frames
a policy called budgetary policy or fiscal policy. So, the fiscal policy is concerned with
government expenditure and government revenue.
Fiscal policy has to decide on the size and pattern of flow of expenditure from the government
to the economy and from the economy back to the government. So, in broad term fiscal policy
refers to "that segment of national economic policy which is primarily concerned with the

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10. Administrative Problems in Democratic Countries: In a democracy fiscal policy

measures must be a time-consuming process. Legislative actions, administrative tasks and the
executive process are often delayed and the original estimates of revenue earnings and
government expenditures often become irrelevant. The operational lag relating to fiscal
measures results in a considerable erosion of effect and the gap between expected achievement
and the real attainment often becomes vast.

MONETARY POLICY V/S FISCAL POLICY

BASIS FOR FISCAL POLICY MONETARY POLICY

COMPARISON

Meaning The tool used by the government in The tool used by the central
which it uses its tax revenue and bank to regulate the money
expenditure policies to affect the supply in the economy is
economy is known as Fiscal Policy. known as Monetary Policy.
Administered by Ministry of Finance Central Bank
Nature The fiscal policy changes every The change in monetary
year. policy depends on the
economic status of the nation.
Related to Government Revenue & Banks & Credit Control
Expenditure
Focuses on Economic Growth Economic Stability
Policy instruments Tax rates and government spending Interest rates and credit ratios
Political influence Yes No

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